5 reasons to like fixed-interest ETFs

This is a snippet from Morningstar's latest ETFInvestor. Premium subscribers can view the report here.

Fixed interest as an asset class is becoming a much more regular part of the discourse on Australian ETFs. While the discussions on ETFs have predominantly revolved around the equity investments, the significance of fixed interest instruments has started to make itself felt, as investors become savvier and gravitate towards balanced portfolios with optimised allocations.

We believe fixed Interest ETFs offer several advantages over direct-bond investing.

Fixed income ETPs trading in Australia (Morningstar analyst coverage)

Source: Morningstar Direct, Morningstar Research. Data as of 1 June 2021.

Why fixed interest ETFs?

1. Diversification and accessibility

Investing in fixed interest ETFs is a more efficient and convenient way to minimize idiosyncratic risks of a portfolio arising out of holdings a select few issues. With the option to achieve a well-diversified portfolio, investors are not only able to protect their principal better but also smoothen out their returns and optimize their risk exposure. It’s much easier for an investor to get a diversified portfolio of bonds via an ETF than it is to build a similar exposure by themselves. This is especially true while constructing a global bond exposure, or when allocating exposures across multiple sectors like government bonds, corporate bonds and securitised assets.

2. Active secondary market

The accessibility benefits go hand-in-hand with the transaction of ETF securities in the secondary markets. Compared with an individual bond portfolio consisting of similar underlying instruments, an ETF portfolio tends to have significantly higher liquidity since the units can be easily traded in the secondary markets with comfortably manageable ticket sizes. This further results in a superior level of transparency, ease of transaction and efficient price discovery. As the participation in fixed Interest ETFs has increased and market makers have optimised their operations, bid-ask spreads have declined – making the ETF route even more attractive.

3. Clear mandates and disclosures

The open-ended nature of ETF investments requires lesser supervision from an investor since the proceeds of the maturing securities are reinvested into the fund without any direct action required from the investor. ETFs are run according to a set of stated objectives and mandates which help investors identify the role of the investments in their total portfolio. Also, fund disclosures can provide clarity over the nature of the risks contained in a fixed interest ETF, such as credit exposure, duration and maturity profile. This control is particular advantageous when rebalancing one’s total portfolio via partial/full redemptions, made easy by the existence of liquid secondary markets.

4. Regular income stream

Since the portfolio of an ETF consists of a multitude of different securities, and hence different maturity and coupon payment dates, the ETF can provide a much smoother flow of income distributions compared to standalone bond investments.

5. Fees

Not only from the view of simplifying portfolio construction amid the mounting pressure to deliver yield with optimum diversification, fixed income ETFs also present a compelling case for lowering overall portfolio costs. Compared to an average equivalent unlisted strategy, the ETFs are more appealing with fees less than half of the former.

Australia fees under the microscope

Source: Morningstar Direct, Morningstar Research. Data as of March 31, 2021.