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Why investors are racing to fixed-interest ETFs

Anthony Fensom  |  26 Nov 2019Text size  Decrease  Increase  |  
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Interest rates globally are heading lower and investors have been quick to follow. Demand for fixed-interest exchange-traded funds has surged in line with tumbling yields and rising prices, giving bond investors reason for cheer amid global uncertainties.

The latest data points to Australian investors’ continued fixation with fixed income. Among the top five ETF inflows for October, fixed income headed the list with around $372 million invested, outpacing international and Australian equities, according to BetaShares.

The Australian ETF industry has continued its rise, finishing October with a record $57.2 billion in funds under management, up 40 per cent over the past year with a more than $16 billion annual gain.

From barely a dozen fixed-interest ETFs five years ago, there are now nearly 30 Australian and global funds, with more in the pipeline.

“If you look broadly at the interest in ETFs, a large amount are low-cost, passive vehicles,” explains Tim Wong, director, manager research at Morningstar.

“There’s a broader industry shift towards emphasising cost and as a result it’s no surprise that you’ve seen fixed-interest ETFs enjoy some meaningful inflows.”

Wong also pointed to other advantages of ETFs, including flexibility, ease of transacting, a high level of transparency and low management fees, particularly for “passive” ETFs that seek to track a benchmark compared to their “active” counterparts.

More inflows could be coming if self-managed super fund and other investors start increasing their portfolio allocations. Debt securities comprised barely 1.5 per cent of total SMSF assets as of the June quarter 2019, compared to the around 30 per cent held in listed shares, according to Australian Taxation Office estimates.

Yield decline tipped

Bonds could be set for more gains too, if weak global economic growth continues and central banks from Australia to the US and Asia are forced to send rates even lower.

Capital Economics expects bond yields in Australia and New Zealand to resume their decline in 2020, even if US bond yields increase.

“We think that rising unemployment, sluggish growth and easing inflation will force the [Reserve Bank of Australia] to cut rates to 0.25 per cent by the middle of next year. What’s more, we expect the RBA to cross the Rubicon and launch quantitative easing in 2020, adding to downward pressure on bond yields,” the London-based consultancy said in a 21 November report.

“In New Zealand, we expect weak GDP growth and a deteriorating labour market to prompt the [Reserve Bank of New Zealand] to cut rates twice next year, more than investors currently anticipate,” it added.

Capital Economics also expects US Treasury yields to remain relatively low “over the next couple of years,” consistent with sluggish growth and subdued inflation in both the US and global economy.

“In that environment, it is unlikely that the Fed will start tightening policy anytime soon,” it said.

Central banks in China, Japan and the Eurozone are also expected to keep monetary policy loose to counter global and domestic headwinds.

Australian funds

For Australian fixed income investors, Morningstar’s Wong points to a number of highly rated local ETFs.

“Within fixed interest, we believe that passively managed funds, including both unlisted funds and ETFs that track the broad Australian composite bond index, remain highly appealing,” he says.

“The reason is that if you look at the cohort of active Australian bond managers, the dispersion of returns is fairly narrow, so passive looks relatively appealing and they are also relatively low cost vehicles.”

Two Australian fixed income ETFs currently hold Morningstar’s second-highest rating of “silver,” comprising the iShares Core Composite Bond ETF (ASX: IAF) and the Vanguard Australian Fixed Interest ETF (ASX: VAF).

Both track the Bloomberg AusBond Composite 0+ Yr Index, a market cap-weighted index designed to provide “comprehensive” exposure to Australian bonds, including government, semi-government, supranational and corporate bonds. Both silver-rated funds also offer a relatively low annual management fee of 0.2 per cent.

As at 2 November, both funds were showing a one-year return of nearly 10 per cent.

Wong also suggests that “passively managed global bond ETFs also make sense.”

One such fund, the Vanguard International Fixed Interest Hedged ETF (ASX: VIF) was rated “bronze” as at 4 February, with Morningstar describing it as “a credible offering for low-cost global bond exposure.”

Will fixed-interest ETFs continue their strong performance in the year ahead?

Wong suggests it depends on central banks’ actions, particularly if the RBA “acts in an unexpected way” such as by slashing rates lower than anticipated.

Yet with interest rates already at record lows in a number of developed economies including Australia, just how much further central banks can ease policy is a trillion-dollar question.

is a Morningstar contributor.

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