ETF Detective: iShares Composite Bond ETF

Why are the InvestSMART Diversified Portfolios invested in the iShares Composite Bond ETF?

An investor would typically hold an exposure to bonds as part of a broader diversified portfolio for two main reasons:

 as a source of income and

 to provide diversification against the equity portion of their portfolio

Historically an investor in bonds has been able to have both the benefit of an income producing asset as well as the diversification benefit that goes with holding bonds in a portfolio. However, these days, given that central banks have pushed interest rates down to historical lows, an investor has to choose between holding bonds for diversification purposes or finding higher yields in more risky asset classes.

Is it a good time to buy the iShares Composite Bond ETF?

If you take a look at the chart below, for the period from 1995 to 2008 yields from Australian bonds were in the range of 4.5% - 8.5% or around 6% on average over that time period, while inflation averaged around 2.7% over the same period. Investors were being rewarded in real terms, that is they were earning a sufficient return while still maintain the purchasing power of their money over time.

Today, however, the yield you receive from Australian bonds is around 2.5% with inflation hovering around 1.7% at the last print. Given inflation expectations are around 2% and if you assume that the Reserve Bank of Australia continues to maintain its inflation target in the 2% - 3% range than it is quite possible that going forward the income generated from Australian bonds is barely going to keep pace with inflation. Quite a different outcome than what bond investors have experienced over the last 15-20 years.

So if the income I’m likely to generate from a portfolio of Australian bonds (in this case with a large exposure to Australian government and semi-government bonds) is unlikely to generate much of a return above inflation then why hold it? Well for the other reason you hold bonds: diversification.

Does holding the iShares Composite Bond ETF provide diversification?

Bonds typically (but not always!) tend to do well in an environment when equities fall as investors tend to flock to the “safety” of government bonds. In addition, central banks tend to lower interest rates in times of economic distress in order to stimulate growth, a fall in interest rates is a positive for bond prices. The chart below outlines the performance of bonds in an environment where equity markets have fallen by 15% or more. Typically bonds have provided positive returns when equity markets have fallen but that doesn’t mean we couldn’t experience a 1994 situation again, especially if central banks raise interest rates beyond market expectations.

Even excluding the prospect that a market shock might occur there might be other scenarios where it still makes sense to hold a portion of your portfolio to defensive low yielding bonds. For instance a scenario where deflationary pressures persist and central banks are unsuccessful in stimulating growth and therefore inflation remains low, then in that environment bonds are still likely to provide you with a real return, albeit at a slimmer margin than they have done so in the past.

It is important to remember that the holding to the iShares Composite Bond ETF forms part of a broader diversified portfolio and acts as a core holding to defensive bonds while other holdings in the portfolio act to generate higher levels of income or growth. 

Target Weighting of Australian Composite Bonds in the InvestSMART portfolios (as at 31 March 2015)