Last Monday, I wrote about new research from S&P Dow Jones that cast doubt about the ability of active fund managers to add real value. While it largely gave the tick to active equity funds, particularly small and mid-cap funds, in the case of fixed interest funds, it was not very flattering.
To recap, S&P Dow Jones compared the performances of 66 Australian bond funds over 1 year, 3 years and 5 years to 30 June 2016 with the performance of the S&P/ASX Fixed Interest Index. It found that 89% of active funds underperformed (after fees) the index over 1 year, 92% underperformed over 3 years and 89% had underperformed over 5 years. While bigger fixed interest funds tended to do better than smaller funds, at the median (50th percentile) of funds, the underperformance was quite material at 1.09% over 1 year, 1.02% pa over 3 years and 0.99% pa over 5 years.
On this basis, I have concluded that the “best” fixed interest funds are index hugging, low cost exchange traded funds (ETF). That doesn’t mean that there aren’t any really good active fixed interest fund managers, rather it means that on the basis of probability, picking an ETF will be a safer play. Also, unlike equity managers who can parade their distinctive investment approach, bond managers are dealing in a more homogeneous asset. It is thus a lot harder to differentiate Fixed Interest Manager A vs. Fixed Interest Manager B on the basis of investment approach or style.
So, the best fixed interest funds for me are going to be a couple of fixed interest ETFs. But first, a few warnings about fixed interest securities.
Warnings
While I am a great believer in a diversified asset allocation, which includes exposure to the bond market through fixed interest securities, there are many out there (including me) who feel that bond rates have only one direction to head – and that is higher.
To be fair, I have been wrong about the bond market for some time now. However, bond yields have risen quite materially over the last few months. After reaching multi-decade lows in early July, the benchmarrk US 10-year government bond yield has risen from 1.35% to 1.74% on Friday. In Australia, the 10-year government bond yield has climbed from 1.81% to 2.29%.
Australian Government 10 year bond yield – 2012 to 2106
Source: Bloomberg
Going forward, so much will depend on what Janet Yellen and the US Fed does, and whether the pick up in economic growth (that we all want) materialises. If it does, then bond yields will head higher. As yields move inversely to prices, higher bond yields mean lower bond prices. To put this in context, a 1% rise in bond yields from 2.29% to 3.29% would translate to a fall in price of just over 8.5%. That is, a $100 bond would have a market value of $91.54.
The second warning is don’t be taken in by a high “running yield”. This is a concept invented by bond salesmen to make high coupon bonds more marketable. Sure, it’s effectively your first year’s income (expressed as a percentage of the purchase price), but it’s not sustainable. All bonds mature for $100, so if you pay more than $100 upfront for a bond (because the regular fixed interest payment exceeds the yield to maturity), you eventually will need to factor in a capital loss.
The best way to compare different bond returns is through the yield to maturity, which factors in the income return and any capital gain or loss if held to maturity.
The other two factors to consider are duration and credit risk. Bond yield curves traditionally have a positive slope, meaning that the longer the term, the higher the yield. A measure of the length of a portfolio of fixed interest securities is duration or modified duration, expressed in years. Generally, the longer the duration, the more volatile the portfolio is. Some funds also publish a weighted average maturity. If you plan to invest in non-government securities, then you should also consider the credit risk and whether the compensation received (through a higher yield) is adequate.
The best fixed interest ETF
The largest and most actively traded ETFs track one of the benchmark indices, either the Bloomberg Australian Bond Composite Index or the S&P/ASX Fixed Interest Index. Both these indexes include government, semi-government, investment grade corporate and supranational bonds. The S&P/ASX Fixed Interest Index has a slightly longer duration of 5.27 years compared to the Bloomberg index of 4.95 years.
As the table below shows, there is very little difference between the ETFs when compared on the basis of management fee or performance. Because the Bloomberg index has a shorter duration, it hasn’t (and those ETFs tracking it haven’t) quite enjoyed the same return as the Vanguard Index in an environment of falling bond yields.
Fixed Interest ETFS
As I am a little bearish on interest rates, I would be inclined to go for the index with shorter duration – so toss a coin between the iShares IAF or Vanguard’s VAF.
A couple of the ETF providers also have Government Bond ETFs, and in one case, a Semi-Government Bond ETF. These are essentially subsets of the broader index. For a personal investor, I can’t really see the attraction of these. If you were really bullish about interest rates, then you might consider a pure Government Bond ETF as this will have the longest duration.
There are also two ETFs that track investment grade corporate bonds – the Russell Australia Select Corporate Bond ETF (ASX Code: RCB) and Vanguard’s Australian Corporate Fixed Interest ETF (ASX Code: VACF). The duration on these portfolios is shorter at 2.9 years and 3.4 years respectively.
One final note of caution to potential bond investors in regard to expected returns. Because long-term interest rates fell over the 12 months to September, the ETFs in the table above were able to achieve a return for the period of circa 5.5%. However, as the weighted average yield to maturity on the portfolios is just on 2.0%, if the bond market stands still over the next 12 months (i.e. interest rates remain where they are), the effective return on these investments will be much closer to 2.0% rather than the 5.5% achieved in the last 12 months.
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.
