An introduction to bond ETFs

PORTFOLIO POINT: Bond ETFs are a great way for retail investors to diversify their portfolios, allowing exposure to a basket of securities with a small outlay.

Exchange traded funds (ETFs) were first introduced in Australia in 2001. Compared to international markets, Australia has been relatively slow to embrace ETFs and there are currently 51 ETFs listed on the ASX. In March this year, the first bond ETFs were launched by iShares (a Blackrock subsidiary) and Russell Investments. ETFs are exchange traded funds that aim to deliver returns equal to an underlying index before costs and tax.

In bond ETFs, securities comprise bonds issued by a variety of domestic and international corporations as well as the Australian Commonwealth government, state and territory governments and international governments, sometimes referred to as “supra nationals” and semi-government entities. Since ETFs are designed to replicate an underlying index, they are considered to be passive management instruments and the underlying investments change only when there is a change in the underlying index.

The six Australian bond ETFs are:

• iShares UBS Composite Bond ETF (UBS Composite Bond Index)
• iShares UBS Government Inflation ETF (UBS Government Inflation Index)
• iShares UBS Treasury ETF (UBS Treasury Index)
• Russell Australian Government Bond ETF (DBIQ 5-10 year Australian Government Bond Index)
• Russell Australian Semi-Government Bond ETF (DBIQ 0-5 year Australian Semi-Government Bond Index)
• Russell Australian Select Corporate Bond ETF (DBIQ 0-3 year Investment Grade Australian Corporate Bond Index)

The three iShares bond ETFs are designed to replicate the UBS indices (see Table 1 below), all fixed-rate. The Composite Index includes Commonwealth bonds, semi-government bonds, supra nation issuers, and corporate bonds, while the other two ETFs exclude corporate bonds. Notice how many securities are in the Composite Bonds Index, compared to the other ETFs, which gives investors a broad exposure to a diversified group of bonds. In contrast, the Russell Investment ETFs use Deutsche Bank indices with somewhat different parameters (see Table 2 below). However, the Russell Australian Select Corporate Bond ETF only holds liquid securities, which tend to be those issued by Australia’s four largest banks – ANZ, CBA, NAB and Westpac. The UBS corporate ETF has slightly cheaper fees of 0.24% versus 0.28% for the Russell corporate ETF.

Table 1: The three bond ETFs issued by iShares
Note: Total management fees and expenses for iShares funds are calculated as an annual percentage of net asset value.
**As at 18 May 2012
# Does not include changes to the principal due to inflation
Source: FIIG Securities, iShares

Table 2: The three bond ETFs issued by Russell Investments
*As at 16 May 2012
Source: FIIG Securities, Russel Investments

Each of the six funds is quoted on the Australian Securities Exchange under AQUA rules, as published by the ASX. Also, the funds must appoint a market maker to “ensure the development of an orderly and liquid market”. The designated market makers are the dealers or brokers permitted by the ASX to act as such by making a market for the units in the secondary market on the ASX.

Applications for creations and redemptions from a fund must be made by an authorised participant, by completing the requisite documentation and following the operating procedures, as detailed in the relevant documentation that applies to each ETF (procedures may vary). Minimum creation and redemption sizes also vary. In order to create or redeem units, the underlying securities must be easily tradable, so the ETFs tend to mainly cover the lower yielding, more liquid part of the fixed-income universe. Individual investors buy and sell units just like other listed managed-fund investments.

One of the greatest benefits of bond ETFs is that they allow smaller investors to diversify their portfolios. Low initial outlays can provide access to a basket of securities, in contrast to single larger investments in individual securities. However, as the ETFs are designed to replicate indices, they need to allocate their funds in a similar manner to the underlying index. The iShares funds are tied to the UBS indices, so typically have very high exposures to government bonds – if not, in fact, 100% exposure – although that exposure varies with the index. Often government bonds can be purchased direct from the issuer for relatively small minimum investment amounts of $5,000 (some as low as $1,000). I think given the very low risk of these securities, I’d consider direct investment if you have sufficient funds, as I think the benefits of direct bond investment generally outweigh the benefits of the ETFs (see Table 3 below). However, ETFs can be used for the lower yielding part of your portfolio, while direct bonds may be used for the higher yielding parts; they can be complimentary.

Direct investment can, in most cases, offer better returns. For example, just last week NAB launched a subordinated bond which will be listed on the ASX with an indicative floating coupon rate in the range of 2.75% - 2.85% over the 90-day bank bill swap rate (BBSW). When the deal was announced, this equated to a coupon of 6.53% - 6.63% for the first quarterly period. While this security is slightly higher risk than the majority of those in the ETFs, its coupon payment is at least 50bps more than that on offer from the ETFs. Heritage Bank also announced a senior bond issue paying a fixed rate of 7.25%; a very attractive direct investment option in a declining rate environment.

Table 3: Bond ETFs versus Direct Bond Investment

-Bond ETFs	Direct bond investment
Advantages
Designed to replicate an underlying index	Wide variety of issuers
Provide diversification to a portfolio	Wide variety of maturities
Can be purchased in small amounts	Large range of risk/return profiles
Pricing transparency	Potential capital gain or loss if sold prior to maturity
Traded on the ASX	Provides steady income
Simple to understand	Access to fixed, floating and inflation-linked securities, depending on your assessment of the market
Access to international markets	Higher returns than the index
Investments selected by experts	Access to corporate bonds not issued by banks
Overseen by ASIC	Can diversify across sectors
Liquidity	Can tailor maturities to suit individual circumstances
Consistent, regular income	No decision to sell needed as capital will in most cases be returned at maturity
Low cost way to diversify away from other fixed income assets, such as term deposits and listed hybrids
Lower fees than managed funds
Can offer distribution reinvestment plans
Disadvantages
Need to be liquid investments, which reduces return	For the vast majority of corporate and bank bonds, the minimum face value parcels start at $50,000
Passively managed investment, so securities are held to maturity	Traded over-the-counter (OTC) and not through an index
ETFs charge a management fee (while small, it reduces your return)	Price discovery
Buying government securities direct (for as little as $5,000) has potential for higher returns	Potential for illiquidity
Securities purchased may not meet index returns	Must source a broker
Like shares, the value of the investment can go up and down	If forced to sell prior to maturity, there is the potential for capital gain or loss
Investors don't have control about when sales of investments are made
Investors don't have control over the duration of the portfolio
Stockbroking fees apply to buy and sell units
As the funds are listed on the ASX, there is a chance that they could be suspended or delisted
Market making risk
No guarantee of distribution
ETFs are managed investment scheme investments with constitutions, terms and conditions (including fees) all of which are subject to change
Must make the decision to sell to recoup capital
High weighting to government securities on the indices
Source: FIIG Securities

The two ETFs that contain corporate bonds are, I think, better choices for the vast majority of ETF investors. While the iShares Composite index tracks corporate bonds as well as government bonds, the Russell ETF tracks liquid corporates, which are, in most cases, banks. In effect, neither ETF has diversified access to corporate bonds – the iShares Composite includes other bond types, while the Russell specialises in bank bonds – but both of the funds increases the yield to maturity available. This is perhaps reflected in the higher value of total funds invested in ETFs with corporate exposure, compared to other ETFs.

However, it should be noted, given current heightened global uncertainty and a flight to quality, that government bonds have outperformed corporate bonds in terms of price appreciation. Figures 1 and 2 below show the Commonwealth government-based funds’ recent price outperformance compared to other funds.

Figure 1: Price history of iShares ETFs (past two months)
Figure 2: Price history of Russell ETFs (past two months)

Generally, the range of bond ETFs in Australia is small and the securities they invest in are somewhat limited. Direct investment, on the other hand, offers a much greater choice of:

• Risk
• Return
• Maturity dates
• Sectors
• Companies
• Bond type (fixed, floating, inflation-linked)
• Currency

Accordingly, direct investment also offers greater control and the possibility of tailoring to suit individual needs. One of the biggest negatives of bond ETFs is that they currently offer very limited access to corporate bonds. On the one hand, while the iShares offers exposure to corporate bonds, you also get exposure to very low-yielding government bonds as part of the index. On the other hand, the Russell index gives exposure to a very limited type of corporate bond – mainly bonds issues by banks, not bonds from other sectors like infrastructure, retail or transport.

However, the new bond ETF market in Australia is welcome, as it will give smaller investors the opportunity to add fixed income to their portfolio and the certainty of income and lower volatility that the asset class offers. Specifically, the ETF can help quickly cover the lower yielding part of your portfolio effectively, while the direct bond offering helps give targeted access to higher yield – an essential feature in the current environment of low government yields.

There are several alternatives to using bond ETFs:

• Use a bond broker like FIIG Securities, which can sell bonds (fixed rate, floating rate, inflation-linked bonds) in minimum face value lots of $50,000 or $100,000 rather than the traditional minimum $500,000 face value at which such bonds usually trade. Brokers earn their fees on over-the-counter bonds from the spread between their buy and sell prices, after which there is no annual management or other fees. This format is well suited to the self-managed super sector, which seeks to minimise ongoing costs.
• Invest in managed funds specialising in Australian bonds, such as those offered by Aberdeen, PIMCO, Russell Investments and Aviva. Managed funds have higher annual management costs than bond ETFs, because their bond portfolios are actively managed rather than passively tied to a bond index. Also, managed funds lose many of the direct investment benefits, particularly the ability to control and direct your investments and the ability to decide to buy or sell specific investments.

Elizabeth Moran is director of education and fixed income research at FIIG Securities.