While ETFs were first introduced to the Australian market in 2001, it was only in March 2012 that we saw the first ETF backed by bonds. At this time iShares (a Blackrock subsidiary) and Russell Investments created a number of ETFs that seek to replicate the returns of various bond indices. iShares has chosen to benchmark to indices from UBS, while Russell’s funds are benchmarked to the respective Deutsche Bank indices.
Because of the nature of the Australian bond market, where government, semi-government and senior bonds from the Big Four banks dominate, these funds have the majority of their exposure to these same assets. This is good in that these issuers are very low risk and offer the funds the highest levels of liquidity, enabling them to meet unitholders fund requirements. However, as the funds are exposed almost exclusively to the lowest risk issuers in the market, the returns are also low.
What are the different funds?
Both iShares and Russell offer three funds: iShares offers funds that invest in a mix of all bonds (the composite fund), inflation-linked bonds (the inflation fund) and government bonds (the government fund). Russell offers funds investing in government, semi-government and corporate bonds. They have detailed mandates for each fund, but essentially, you get what’s written on the label.
What are the returns?
In general, you expect corporate bonds to offer a higher running yield than government bonds, reflecting the increase in risk (as government bonds are seen as the ‘risk free’ benchmark in their respective markets) and you would expect to see more movement in the capital value of government bonds (both up and down) as these are the bonds traded in the highest volume by government treasuries around the world, with the capital movement reflecting the overall performance of the economy. The returns are made up of price movements in the units and their distributions.
The best return recorded was from the Russell corporate bond ETF, returning 4.06% for the year ended 30 June 2013, while the worst performer was the UBS inflation bonds fund, returning -1.65% for the year to 30 June 2013.
[1]Investors looking at gaining exposure to a broad range of bonds would have focussed on the iShares Composite fund and the Russell Select Corporate fund, with Russell coming out on top by 1.53 percentage points: 4.06% for the year versus 2.53%.
Are bond ETFs for you?
Ultimately, the returns on all of these funds are a little disappointing to the naked eye, but the returns reflect the nature of the underlying exposures taken by the funds; ie. a significant exposure to very low risk government, semi-government and senior bank bonds.
They do, however, offer a cheap and easy way for investors to diversify their investment portfolio – something that is under appreciated and not well understood by the Australian investment market. Holding a mix of bank, infrastructure, industrial and small cap shares is NOT a diversified portfolio. The big super funds invest in bonds for a reason, and Australia’s burgeoning SMSF market should imitate the professionals and do the same.
An alternative
One of my favourite bonds over the last year has been the Sydney Airport corporate ILB. As a corporate bond, it carries more risk than a government bond, however has an investment grade rating and is supported by a monopoly infrastructure asset. The Sydney Airport ILB (2020 maturity) offered a holding period return (i.e. capital gain plus distributions) of 7.16% for the last financial year, not just a positive return, but a return considerably higher than the ILB ETF.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
Also in the Switzer Super Report:
- Charlie Aitken: Why Woodside is a yield play [2]
- Olivia Long: My SMSF [3]
- Roger Montgomery: Blackmores – not quite what the doctor ordered? [4]
- Penny Pryor: Buy, Sell, Hold – what the brokers say [5]
- Tony Negline: SMSF assets and ownership [6]
- Paul Rickard: Question of the week – Safe investments [7]