Should your SMSF buy the new fixed-income ETFs?

Co-founder of the Switzer Report
Print This Post A A A

As with most new products, there is a lot of hype about fixed-income exchange-traded funds (ETFs). While not new globally, the ASX has made some listing rule changes and hence the first Australian fixed-income ETFs have just been launched. I am not a buyer and here is why.

First to the products. Blackrock Investment Management (under the iShares banner) and Russell Investments have launched six index based (passive) fixed income ETFs. Key details are:

Key questions

With passive fixed income ETFs, the key questions are:

  • What type of index does it track?
  • What component bonds comprise that index?
  • What are the management fees (MER)?
  • What is the tracking error?
  • How liquid is it?

Management fees are pretty much the same, tracking error we will find out over time and although liquidity is yet to be demonstrated, on track record you would expect iShares to be stronger. As an aside, the bid/offer spread on the ASX for the Russell Fixed Income ETFs was $0.25, which on an approximate unit price of $20 is 1.25%, compared with $0.10 for iShares, which on a price of $100 is 0.10%. Some difference!

Now to the index. The iShares Composite ETF tracks the UBS Composite Bond Index and probably gives the broadest exposure to the Australian fixed-interest market. It is weighted approximately 35% Government Bonds, 31% Semi-Government Bonds (issuers such as the NSW Treasury Corporation), 18% Supranational (issuers like the World Bank who issue Australian dollar bonds) and the remainder in bank and corporate bonds. It covers all maturities.

On the other hand, the iShares Treasury ETF tracks the UBS Treasury Index. This is a sub-index of the UBS Composite Bond Index, and comprises government bonds only. Given that so much of the composite bond is weighted towards government and semi-government bonds, and the lower yield on government bonds, go no further with the iShares Treasury ETF.

Russell’s ETFs, which are currently tiny in size, track respectively Government Bonds, Semi-Government Bonds and Corporate Bonds. The former are tracking indices from Deustche Bank weighted towards bonds with long dated maturities (five to 10 years), while the Corporate Bond is tracking shorter dated maturities. For yield, the Corporate Bond ETF might be of interest; however, the index only currently includes bonds issued by the four major banks and is too narrowly based.

Which is best?

So, it is a pass on all the Russell fixed-income ETFs. The iShares Composite should fit the bill for an SMSF looking for a passive fixed-income investment, and the iShares Government Inflation ETF, which tracks inflation indexed bonds, could have a role for an SMSF portfolio in the pension phase. However, there just aren’t that many government inflation indexed bonds on issue and the EFT may struggle to attract critical mass.

That said, I am not a buyer at the moment of any fixed-income ETFs.

Low yields

Why not? Interest rates on government bonds are at multi-decade lows or near lows, and I just can’t get excited about an average yield to maturity of 4.47%.

Let’s go back to the iShares Composite Bond ETF, my preferred fixed income ETF. As almost two-thirds of the index tracks government and semi-government bonds and the yield on a 10-year government treasury bond is a fraction over 4%, it is not surprising that the current yield to maturity for the EFT is only 4.47%. While it has a higher running yield of 5.65% (due to most government bonds being issued some years ago with higher coupons), it is the yield to maturity that counts.

I am not in the school that says the “world is about to end”, and over the medium term, I expect long-term bond rates to go higher. If my scenario proves to be correct, investors in these ETFs face the prospect of (on paper) capital losses.

If I am wrong, I think you can still do better elsewhere.

Other options

It is hard to go pass five-year term deposits at 6.5%, on offer currently by both Macquarie Bank and RaboDirect. And, deposits of up to $250,000 (per investor per financial institution) are government guaranteed!

There are also good alternatives with managed (active) fixed-interest funds. The debate between passive (or index) management and active management is always interesting, and perhaps because in my youth I was a fixed-income trader, I take a slightly different view when it comes to fixed-income than with equities. More on this another day.

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Also in the Switzer Super Report

Also from this edition