Bonds can play an important role in a diversified portfolio, but compared to other developed markets, they're relatively unpopular among everyday investors in Australia. 

But after years of lacklustre yields as a result of ultra-low interest rates, the appeal of bonds is now on the rise.

We identify two high quality fixed income ETFs for investors looking to get exposure to the bond market.

Flows strong to fixed income

ETF flows have had a choppy start to the year, according to data from Morningstar.

In January, net flows – that is, the net movement of cash into and out of Australian ETFs – fell to its lowest level since the start of the pandemic, before rebounding slightly in February and March.

Morningstar analyst Kongkon Gogoi says the erratic flows are reflecting volatility in the overall market, pointing to ongoing fears of a global recession, banking jitters in the US and Europe and persistent inflation as causes for investor uncertainty.

But while total ETF flows have remained broadly erratic, ETF provider BetaShares says flows towards cash and fixed-income offerings have remained strong.

Betashares ETF flow data

This trend is also being reflected globally, with flows to government bond ETFs worldwide surging to US$33.2 billion in March, higher than the previous peak of US$27.4 billion set in May 2022, according to data from BlackRock.

Morningstar portfolio analyst Amy Arnott says bonds can still play a critical role for investors in reducing portfolio risk, even in the rising interest rate environment that has hit the asset class in the last 12 months.

“Stocks and bonds tend to move more in tandem during inflationary periods, but bonds can still provide significant diversification benefits as well as play a critical role in providing ballast and reducing risk at the portfolio level,” she says.

But for Australian investors seeking the relative safety and regular income of bonds, there are fewer choices, with just 48 funds offering fixed-income exposures compared to more than 650 in the US.

Two gold-rated, fixed-income ETFs

Morningstar investment specialist Susan Dziubinski says the Morningstar Analyst Rating can provide a good starting point for investors.

“ETFs that earn our highest rating—Gold—are those that we think are most likely to outperform over a full market cycle,” she says.

Of the nine Australian ETFs rated Gold by Morningstar, only two fall into the fixed-income category: iShares Core Composite Bond ETF (IAF) and Vanguard’s Australian Fixed Interest ETF (VAF).

Both funds track the Bloomberg AusBond Composite 0+ Index, which is designed to measure the nation’s debt market and consists mainly of Australian government and semi-government bonds.

Morningstar analyst Zunjar Sanzgiri says iShares’ Core Composite Bond ETF stands out as one of Morningstar’s top picks for investors seeking exposure to Australian fixed income.

Reviewing the fund last year, Sanzgiri says Morningstar continues to hold a strong conviction in the ETF's ability to outperform over its peer group through a complete cycle.

Similarly, Gogoi notes Vanguard’s Australian Fixed Interest ETF as an excellent choice for diversified Australian bond exposure that has typically done well when equity markets are weak.

“As a core bond holding, this strategy has served investors well over time by bringing broader portfolio volatility down and protecting capital when equity markets slide,” Gogoi says.

Price war drives fees down

An ongoing price war between BlackRock's iShares, Vanguard and Betashares has driven fees to new lows in recent months.

In February, Blackrock slashed the annual fee for iShares Core Composite Bond ETF to just 0.1%.. which was matched by Vanguard this month.

Dziubinski says investors should pay particular attention to fees when considering bond ETFs.

“Every extra point paid in expenses is one less point in return, and returns are typically tougher to come by with bonds than with stocks,” she says.