If you think equities markets have run too hot this year and are due for a fall, now may be the time to increase your allocation to exchange-traded bond products.
The All Ordinaries index started the year at about 5750 points and has been climbing towards 6000 points since then.
While it is impossible to predict the direction of markets, what goes up can come down and such large market gains can point to an imminent correction.
When equities fall, bonds tend to rise, which may be one reason fixed-interest exchange-traded funds have become so popular with investors this year.
Fixed-interest ETFs well and truly trounced equity ETFs in January, with a $165 million reduction in funds in these products in the first month of the year, according to BetaShares’ data.
In contrast, bond ETFs, which have attracted $180 million in retail investor funds since the start of the year, are expected to remain popular with investors.
A bond ETF is an exchange-traded fund that provides exposure to a portfolio of fixed-income securities.
They give retail investors access to a cost-effective diversified portfolio of bonds and there is a range of different bond ETF options listed on the Australian Securities Exchange.
Their performance is generally designed to track a fixed-income index across markets such as Australian corporate bonds, global bonds and emerging market bonds.
The rising popularity of bond ETFs followed the earlier rise of equities ETFs, the first form of this instrument to become popular with retail investors. They are popular because they are easy to trade on major stock exchanges, so they feel familiar.
BetaShares’ managing director Alex Vynokur says : “We often find there is an evolution in the way investors use ETFs from broad market equities products to other asset classes, including fixed-income.
“Continual market turbulence has added impetus for investors to diversify their portfolio beyond equities. We’re also finding more financial advisers are building investment portfolios entirely from ETFs and are using bond ETFs to fill the fixed-income allocation,” he says.
Bond ETFs provide diversification beyond shares because their returns are typically uncorrelated with equities markets. So including bond ETFs helps reduce volatility in portfolios.
But ultimately, they are just a really easy way of getting an exposure to the Aussie bond market.
“Retail investors can buy an Australian bond ETF and get returns that are very close to those generated by the local bond market,” says Matthew Arnold, State Street Global Advisers’ head of ETF strategy and research for Asia Pacific.
Another reason why mums and dads have started investing in bond ETFs is because some allow them to access areas of the global fixed-interest markets that were hard to get to for the average investor in the past.
“With bond ETFs, investors can access most areas of the global bond market using essentially the same process they use for buying single stocks on exchanges like the ASX,” says Arnold.
Kris Walesby, head of ANZ ETFS, says bond ETFs allow non-institutional investors to allocate funds to fixed-income assets without having to buy the underlying bonds themselves, which are normally very expensive. He says it could cost $500,000 for just one small bond unit.
“Through a bond ETF an investor can buy a diversified portfolio of bonds for what would normally cost an investor a minimum of $20 million,” he says.
Walesby says another reason bond ETFs have become popular is because investor appreciation of the importance of having bonds in a portfolio has risen.
“More Australians, especially retirees, are using bond ETFs to produce yield to complement their equities. Bonds produce significant risk-reducing benefits to a predominantly equity-based portfolio,” he says.
Fees also make bond ETFs attractive: they tend to have lower management fees compared to actively managed bond funds.
“While investors may be willing to pay higher fees to receive commensurately higher returns through active management, it’s quite difficult for active fund managers to consistently outperform the passive alternative in fixed-income as well as equities,” Arnold says.
Funds do not have a set maturity and distributions are paid monthly instead of semi-annually. “This gives investors access to regular income flows,” says Julia Lee, equities strategist, Bell Direct.
Transparency is another benefit. Holdings are published on a daily basis so investors know exactly what they hold at any point in time.
Remember, however, not all bond ETFs are created equal and it pays to understand what you are investing in before allocating funds to these products.
For example, says Vynokur, should investors buy a bond ETF whose capital returns are tied to interest rates they should be aware that, in a rising interest rate environment, capital returns of the ETFs are likely to fall.
“If investors are buying corporate bond ETFs they should be aware that they will be exposed to the underlying creditworthiness of the issuers associated with those bonds, and make sure they are comfortable with that,” he adds.
Says Lee: “Levels of risk can differ substantially between different bond ETFs so investors still need to research which product may be the most suitable for them. Prices for bond funds also fluctuate. So investors should be aware that the price the ETF trades at should be near the net tangible asset value.”
It is also worth remembering investors who choose to buy a passive bond ETF will only receive the market’s performance and will not generate outperformance.
So if you want to outperform the market with your fixed-income exposure, passive bond ETFs may not be the answer.
“Bond ETFs have made fixed-income investing easier for a range of investors, but most of them aim to deliver the returns of the market segment they are tracking,” says Arnold.
“So if Australian bonds sell off, the value of bond ETFs tracking that segment of the market will also decline,” he says.