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How to generate income without equity risk

The recent step down in cash rates was a final jolt to the savings of millions of Australians who live on interest from bank deposits. It took term deposits to 2% or less, barely keeping pace with inflation, while many savings accounts now pay negligible interest.

The temptation to invest in bank shares rather than bank deposits to sustain a living standard will be too strong to resist for many. However, it introduces a risk which conservative savers may come to regret as they hanker after the returns of the past, as shown below in the cash rate since 1990.

Source: RBA

Facing up to the TANSTAAFL

People living on income from their savings face an uncomfortable truth. Any investment that is not a short-term bank deposit or government-guaranteed bond carries added risk. The TANSTAAFL, better known as ‘there ain’t no such thing as a free lunch’, is the reality of investing in a low interest rate world.

Over the last decade, the merit of bank deposits has changed dramatically. For example, in December 2009, Westpac offered a 5-year term deposit paying 8%. It attracted $2 billion in a week and Westpac quickly closed it. That term deposit sat in the retirement portfolios of thousands of Australians until 2014, and it’s been a rapid downhill since.

At the time retirees grabbed the Westpac deal, few people would have thought they would never see such a good rate on a bank deposit again in their lifetimes, even if they live until 100 years-of-age. For guaranteed income, it’s more ‘lower forever’ than ‘lower for longer’.

The risk appetite of every person, or acceptance of the reality of TANSTAAFL, varies according to their circumstances. Some older people with good savings capable of financing their later years and perhaps the need to buy into a retirement facility, cannot risk losing their capital. They may need to accept the 2% or less returns.

Other people with more lifetime options can accept some risk for extra return, so let’s survey the income landscape in the listed market on the ASX, excluding investments that carry equity risk. Across Listed Managed Investments, Exchange Traded Products and its mFunds service, the ASX identifies 92 Australian and 38 global fixed income products. It’s a far bigger range than most investors realise.

As an indication of how competitive and broad the listed sector has become, Vanguard now has seven fixed income ETFs while BetaShares has five. In fact, in FY2019 as shown below, fixed income ETFs generated larger inflows than any other asset class including Australian equity and global equity. It’s a major change in investing habits and the first year this has ever happened.


Source: BetaShares, year to 30 June 2019

This article focuses entirely on the listed market to demonstrate the choices, but the range of unlisted managed funds is even larger.

1. Cash

The least-risky listed products are ETFs which invest in bank deposits with short duration. The largest is the BetaShares Australian High Interest Cash ETF (ASX:AAA), while UBS issues the UBS IQ Cash ETF (ASX:MONY) with similar assets. Blackrock issues iShares Core Cash ETF (ASX:BILL) which can invest in a wider range of short-term securities. All these ETFs have returned around 2% in the last 12 months, but their returns will fall in line with cash and bank bill rates.

2. Cash-enhanced and floating rate notes

Staying in short-duration investments but adding securities with slightly better returns are the VanEck Vectors Australian Floating Rate Bond ETF (ASX:FLOT), the BetaShares Australian Bank Senior Floating Rate Bond ETF (ASX:QPON) and iShares Enhanced Cash ETF (ASX:ISEC). The extra income comes from buying notes with maturities up to five years, but it comes with a little extra risk because prices of such instruments fluctuate more than cash or bills. Again, returns are likely to follow cash and bill rates.

3. Investment-grade bonds

Now the field really starts to expand as many fund managers offer bond funds which invest in investment-grade credits rated BBB+ or better. With these high ratings, a diversified portfolio should produce acceptable credit risk, and the exposure to interest rates depends on the duration of the bonds. Each fund manager will accept different risks depending on their perception of the opportunities. There are also index funds which have lower fees.

Examples include Vanguard’s Australian Corporate Fixed Interest Index ETF (ASX:VACF) which invests in investment-grade Australian corporate (ie non-government) bonds, while less risky is Vanguard’s Fixed Interest Index ETF (ASX:VAF) because it also includes government bonds. Russell issues its Australian Select Corporate Bond ETF (ASX:RCB) and BetaShares has an Australian Investment Grade Bond ETF (ASX:CRED) and an Australian Government Bond ETF (ASX:AGVT).

These funds usually introduce duration risk which benefits from falling interest rates, and therefore their one-year returns have been impressive as rates have fallen. But here’s where TANSTAAFL kicks in. Future returns depend on the movement of interest rates, and these funds will suffer when rates rise. The decision for the investor, therefore, is not so much credit risk as interest rate risk at this ratings level, although we saw in the GFC how ratings agencies don’t always understand the real risks.

A competitor stock exchange, Chi-X Australia, will join the mix soon with the launch of its own funds market in second half of 2019. It will offer a range of both ETFs and Quoted Managed Funds (QMFs). Around 36% of all Australian ETF trading already takes place on Chi-X so the Funds Market is a logical next step.

4. Higher-yield products

As bonds purchased move down the ratings spectrum, default risk on lower credit quality names starts to become a major TANSTAAFL factor. The benefit of investing with a quality fund manager is their portfolio might include hundreds of issuers with no more than 1% of the exposure to one name, such that a modest number of defaults does not erode capital. However, in a severe economic downturn, the lower credit quality may cause losses. Investors need to weigh the merits of return versus risk.

In the actively-managed ETF space, the BetaShares Legg Mason Australian Bond Fund (ASX:BNDS) carries exposure to government bonds as well as semis, corporate bonds and asset-backed securities, managed by Western Asset.

Moving away from ETFs to Listed Investment Products, the individual fund characteristics vary. Operating in the global market across issuers in many different countries, credit qualities and industries is the Perpetual Credit Income Trust (ASX:PCI), which aims to hold 50 to 100 issues with an overall target return of the RBA cash rate plus 3.25% after fees, over the cycle. The Neuberger Berman Global Corporate Income Trust (ASX:NBI) is even more diversified with 450 global holdings, and it works on a declared annual distribution level, currently 5.25% paid monthly. Vanguard’s most popular global offer is their International Fixed Interest Index ETF (ASX:VIF).

Coming soon, Chi-X will quote its first series of actively-managed fixed income QMFs including ActiveX Kapstream Absolute Return Income (CXA:XKAP) with target return of RBA plus 2-3%, Schroder Absolute Return Income (CXA:PAYS) with target return of RBA plus 2.5% and various eInvest Daintree Capital funds with target returns up to RBA plus 3-4%.

In Australian credits, the Metric Credit Partners MCP Master Income Trust (ASX:MXT) holds a portfolio of directly-originated corporate loans, rather than buying public bonds, with a target return of RBA cash plus 3.25%. Gryphon’s Capital Income Trust (ASX:GCI) invests in asset-backed securities (or securitisations) issued in Australia and targets cash plus 3.5%.

Of course, all these targets are not guaranteed but more like manager aspirations.

At this end of the market, skill and diversification play important roles to manage TANSTAAFL. The reason a manager may deliver 4% or 5% rather than 2% is the added risk dimension.

There are a few ‘notes’ listed on the ASX which don’t receive much attention, are unrated and not highly liquid, but their structure offers good investor protection. They are debt instruments backed by the assets of a larger Listed Investment Company structures. Two examples are NAOS’s ASX:CAMG and Whitefield’s ASX:WHFPB.

5. Hybrids

Hybrids have become a major part of the credit structure of many companies, particularly banks. They mix characteristics of debt and equity but come in a vast array of variations. It is not possible to summarise all the alternative choices here, but they are certainly not all created equally. Many mandatorily converted to equity in certain events, or have their coupon payments suspended.

Margins over the bank bill rate vary according to expected first call date, investor appetite and issuer funding needs, and they are lower in the bank capital structure than senior and subordinated debt, but above shareholder equity. While difficult to generalise, major bank hybrids currently offer up to 3% above the bank bill rate (including franking benefit).

Morningstar has a couple of four-star rated hybrids as at 31 May:  Macquarie Group Capital Notes 2 (ASX:MQGPB) carrying a ‘running yield’ including franking credits of 6.44% and Ramsay CARES (ASX:RHCPA), with a running yield of 6%.

For those who prefer not to face the idiosyncrasy of individual issuers or tranches, BetaShares offers the Active Australian Hybrid Fund (ASX:HBRD) with expert selection from the hybrid universe.

6. Other listed products

Two other products are worth mentioning:

mFunds

To improve access to unlisted managed funds, the ASX has an execution service which allows investors to buy and sell managed funds through a participating broker. There are 221 mFunds holding almost $1 billion, of which 19 are Australian fixed income and 29 are global fixed income. Major brands such as Legg Mason, PIMCO, Schroders and AMP are represented.

XTBs

Rather than investing in broad fixed income sectors or funds as with most of the examples in this article, Exchange Traded Bonds or XTBs allow retail investors to choose specific borrowers who have issued bonds in the Australian wholesale market. Buying a bond of a single company removes the benefits of diversification.

Don’t forget the TANSTAAFL feeling

Some of the highest income potential in the listed market comes with an acceptance of risk in other asset classes such as property, shares and infrastructure. Balanced funds provide combinations of assets to match risk appetites.

This is where TANSTAAFL dominates. While a fund might call itself ‘equity income’, it will invest heavily in shares with an income bias, such as the banks and Telstra. There is the tradeoff. A bank might offer a dividend of 8% including franking, but the share price could fall heavily in a market correction, and dividends may suffer in an economic slowdown. This week, we saw AMP suspend its dividend.

Investors in this space must accept TANSTAAFL as the total return from good income may be outweighted by falling capital values.

Also consider investment costs. Placing only $5,000 in a listed product for a 0.5% yield pick up is only $25 a year, which barely covers brokerage and management expenses. It might be better to accept 2% on a term deposit. Take care with some cash-enhanced funds that stray into unusual securities without a reward for the risk.

 

Graham Hand is Managing Editor of Cuffelinks. This article is general information and does not consider the circumstances of any investor, and professional advice should be sought. There are no recommendations in this article. And repeating that the article only focuses on the listed market and there are many unlisted choices.

For more information on the ETFs and LICs mentioned in this article and many more, visit our Education Centre for regular reports. In particular, ETF Reviews are here.

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19 Comments

eric

September 08, 2019

Amazingly helpful, thanks so much. surely though, the experts really make their money by trading in and out of various bonds / ETFs etc at the 'right' time?

James

August 12, 2019

I have addressed falling ‘risk free’ returns by adopting a barbell risk approach – keeping 80% in cash and physical gold and taking more risk with 20% in Aussie equities. One thing the GFC highlighted was the importance of diversification, especially credit risk. Innovation and disruption of established industries like banking and healthcare have a long way to go providing some excellent risk reward tradeoffs. Given the downward trajectory of $A, the article makes no attempt to maintain or even enhance the wealth of a global citizen who happens to live in Australia

Warren Bird

August 10, 2019

Interesting article. I found it helpful.

One of the most critical bits of information you need about any fixed income investment – be it a single bond, a managed fund or a listed vehicle – is the yield to maturity when you make your investment in it. That will always be the single best estimate of the return you’ll get from this investment.
For a single bond, it’s an almost 100% accurate estimate, but for a portfolio it’s still a very good predictor. With one proviso. You also need to know the maturity of the bond or the average maturity (duration) of a portfolio. The yield will be the return over that period. Over shorter periods, the return will be dominated by capital price fluctuations; and over long periods, reinvestment of maturing bonds will result in a different yield profile.
The one thing that’s totally irrelevant is the return historically, in particular the return last year. Lots of bond funds and bond investments have had stellar returns in 2018-19, because the fall in yields has created capital gains. All that really means is that the returns embedded in yields 12 months ago have partly been brought forward and per annum outcomes over the remaining maturity period will be lower.
You’ll also need to look a lot further for useful information than the ASX website. It’s set up as if ETF’s and LIC’s are shares, so doesn’t give the forward looking information that you really need for bond portfolios.
Let me illustrate by checking out one of the funds Graham has mentioned. Totally arbitrarily I’ve chosen the Russell Select Corporate Bond ETF (ASX.RCB). I’ve tried to work out what’s going on with this fund by looking at the ASX website for it; then I’ve gone to the Russell website.
The ASX website tells me that this is a 0-3 year fund. By contrast, the Russell website tells me that this is a 0-4 year fund. Let’s ignore that difference for a moment. Either way, this tells me that the fund’s price won’t be too volatile, as it’s in some way going to be focussed on shorter term bonds and not 10 year bonds. This lack of volatility is confirmed by the chart that the ASX gives me that shows a price between around 20 and just over 20.5 over the past few years.
The ASX shows me the dividend history. This year (2018-19) we had 3 interim divs of around 14 c each and then a final div that’s much larger at 44c. It’s usual for any managed fund (and an ETF is just a managed fund that’s in a listed vehicle) to hold back some of the income accrued during the year so that the final quarterly payment is a bit bigger, not smaller, than the others. But such a large jump suggests to me that there’s been some realised capital gains that have had to be distributed as well.
I’d have an idea of how much that is if the website gave me a history of the average yield to maturity of the portfolio. Then I could look at what it was a year ago and compare that to the realised dividend yield of 4.3%. I’ll get that from the Russell website, but if all I was relying on was the ASX then this is how I go about it.
What I’ve done is to work out the average yield that the 3 interim divs represent, per annum, which is about 2.7%. (Add them up, divide by 3, multiply by 4 and then divide that by the price at the start of the year.) Assuming a little bit of income was held back each time, then it seems that the underlying income earnings of the fund were about 3%. So the final dividend reveals about 1.3% of capital gains that have been distributed. But this is just a rough estimate from imperfect information.

So, now I go to the Russell website and, voila, they tell me there that the ‘running yield’ of the portfolio is 3%. So my calcs seem to be on the money. I can also find out that the total return of the fund last financial year was 7.2%, including 2.7% from growth, on top of the distribution return. That figure shows me the unrealised capital gains sitting in the fund.
What we have then is a yield or income amount of about 3%, plus 2.7% of unrealised gains and another 1.3% of realised gains paid in the distribution. So that’s 4% of capital gains.
That makes sense since Russell also tell me that the duration of the fund is 3.5. I know from other sources that bond yields in the 3-4 year part of the market fell during 2018-19 by about 1.1%. Multiplying 1.1 by 3.5 is 3.85, which is close to 4% so we’re in the ballpark.
The Russell website also tells me that at 30 June the ‘yield to worst’ (similar to the yield to maturity) is 1.75%. They don’t give me historical information, but I’m inferring that a year ago this yield to worst number would have been more like 2.85%, adding back the 1.1% that I know about from general market information. That drop in yield produced the capital gains that boosted last year’s return, but now means that, going forward, I can expect the total return on an investment in this ETF to give me 1.75% per annum before fees over the next 3-4 years.
If yields fall another 1% this year, then the fund will give me a solid return of about 5% after fees. But after that, yields will be at 0.75% so the return in the next couple of years will be down at that level. Do the math – a year 1 return of 5% followed by 0.75% per annum for 3 more years delivers an average result of 1.75% per year.
Every fund will be nuanced, holding different bonds. You have to take credit risk into account – some could lose capital if there’s a default. But the core maths of how to understand what you’re getting into needs those two bits of information at the very least – yield to maturity and average maturity (or duration) when you make the investment.

And finally, the prospective return on this Russell investment is not all that different to term deposit rates on 3 year terms at the banks at the moment. That’s not really surprising since the holdings in this ETF are all bank bonds maturing in 2022 and 2023. So that’s one more bit of information worth getting about an ETF – the securities it holds. Again, you can’t get that from the ASX website, you need to go to the manager.
Let me then call on the ASX to improve the quality of its information on bond ETFs and the like as a service to investors.

Phil

August 10, 2019

Hi Warren, to educate us further could you explain your preference for Yield to maturity vs Running Yield and the difference. For example the Vanguard Aust Fixed Interest Fund has a Yield to maturity of 1.41% and running yield of 3.43% – a big difference in estimating solely income. Which is more correct?

Warren Bird

August 10, 2019

It’s not a case of one being “more correct”. It depends on what you’re trying to figure out.

Running yield is the amount of income divided by the current market price. It’s a simple calculation, similar to dividend yield on stocks.
Yield to maturity is based on the Net Present Value (NPV) of income and capital amortisation. This gives a better estimate of total return over the life of the bond.

So a $100 bond trading at $95 with a coupon interest rate of $4 has a running yield of 4.2% (4/95). But the yield to maturity of that bond is more than this because it takes into account the amortisation of that bond back up to $100 at maturity.

In this case, the yield to maturity is higher than the running yield because amortisation is positive – the bond’s capital value increases. How much depends on the maturity of the bond. If it’s 5 years from today, then amortisation is $1 a year, so the yield to maturity will be an NPV calculation based on $5 of income a year = $4 in interest + $1 capital appreciation. That will be a bit over 5%.

Yield to maturity is, most of the time, similar to running yield. But when you’ve had a big move in the market since the bond was issued, you’ll get a difference like in the example I just gave, in which yields have risen and the bond’s price has fallen below par.

Or in the Vanguard case you’ve mentioned, yields have fallen for most of the bonds so that the average price is above par. That means there’s negative amortisation to be deducted from the running yield when the yield to maturity is calculated.

It looks like this Vanguard fund will pay a distribution income rate of 3.4%, but the unit price will drift lower by around 2% a year to give a total return over time of 1.4% pa.

Most funds, rightly, say that their yield to maturity is ‘not a forecast’ of the return. That’s because a fund is dynamic, with bonds being traded and strategy for variables such as duration being adjusted quite often. Those things will affect the outcome. So, from a legal disclosure point of view, that proviso is correct. However, yield to maturity is the best starting point you have for estimating the total return, especially when comparing different funds.

That’s a very partial answer, but I hope that it helps. I feel another article coming on.

Lee

August 10, 2019

This article + Warren’s comment would probably be the most educational content I have ever read on fixed income. Thank you very much!

Graham Hand

August 10, 2019

Thanks for the kind comment, Lee. Yes, many people need to learn more about fixed interest opportunities. G

Dudley

August 10, 2019

How to generate income without bond risk – and without sweating?

The Everything Bubble is providing capital gains but reducing current and future yields.

When Yield on Everything disappears down the same black hole and capital gains alternate wildly with capital losses, we will see the birth of a new ‘Alice in Wonderland’ investing universe the mirror image if this one.

Warren Bird

August 10, 2019

Ah Dudley, you need to read a few of my articles. e.g.

https://cuffelinks.com.au/journey-life-fixed-rate-bond/

https://cuffelinks.com.au/really-bond-returns-market-rout/

Even if bond yields rise, over the life of the bond or over a period similar to the average maturity of a fund an investor will still earn the yield at which they purchased the investment.

It would work the opposite of the example I gave in my comment. Buy at 1.75% and watch yields go up by 1% in year 1. In the situation I was talking about that gives a negative return in year 1 of about -2%. If yields stayed there, then in years 2, 3 and 4 the investor will earn around 2.75% per annum. That delivers a positive return of 1.5% per annum over 4 years, without taking into account any reinvestment earnings at the higher yield.

No denying that if you believed that yields were going to post that 1% increase then you’d avoid making the investment then and wait until you could do so at 2.75%. Folk have been doing that since at least 2012 when I spent several months giving presentations to investors urging them not to think that another 1994 was about to hit us. They’ve missed out opportunities to lock in the sort of rates that Graham’s article mentioned.

Now yields are at record low levels. That’s not a bubble. For two reasons.
First is that yields aren’t here because of speculative excess. They’re here because economies aren’t generating a risk free rate of return higher than inflation. We had the cash rate at 1.5% for 3 years and yet the economy chugged along at trend and we didn’t get inflation. If the RBA had artificially forced the cash rate to be ‘too low’ then we would have inflation, but instead it keeps falling and we now believe that even 1% cash isn’t going to work without other sources of stimulus for growth in the economy. (This is a short version of my article https://cuffelinks.com.au/response-montgomery-bond-signals/)

Second is that you can’t have bubbles in bonds. It’s not how the asset class works. Every bond matures at par and the amortisation of bond prices from current levels to par is factored into the yield to maturity so it’s not a surprise. A bubble market results in permanent losses of capital and severe negative returns that can’t be recouped. That’s simply not the case for bonds. You will earn the income and bonds will mature at par!

So, no need to sweat going into bonds right now. If yields go up from here, then you’ll see a negative return early on, but returns in future years will be more than the yield to maturity today.

People have to think about bonds differently to equities – they’re different asset classes entirely.

Dudley

August 10, 2019

Lothe to side track but the underlying the premise of bond certainty is the assumption of 100% certainty of par value being paid at maturity. Beware Greek bonds.

Warren Bird

August 10, 2019

Not a sidetrack, Dudley. I did say that there’s more to it than just YTM and duration, though they are the foundational aspects of estimating returns.

Credit risk is part of the story when you invest in bonds. (And as Ashley has written about a couple of times, even governments like Australia have defaulted in the past. It’s extraordinarily rare, though, and easy to exaggerate the probability of it happening again, but AAA bonds don’t have a zero default rate.)

I’ve written about credit risk, too, (surprise, surprise) – in particular these two articles:

https://cuffelinks.com.au/give-risk-credit-deserves/

https://cuffelinks.com.au/managing-credit-risk-requires-healthy-dose-cynicism/

Key point, though, is that credit risk is a risk to be managed, not a killer for the asset class. If you diversify properly, as I advocate in those articles and have advocated many times since in various places, then:
(a) defaults in your portfolio will be very rare, if at all. In the universe of Investment Grade bonds (AAA, AA, A and BBB) the average default rate is around 2.5%;
(b) losses from defaults will be even less than this because there’s recovery in most situations; and
(c) the asset class will deliver you an attractive return. Which almost all of the time will be driven mostly by the yield to maturity of the bonds in your portfolio.

Therefore, the assumption that bonds reach par at maturity is totally valid and empirically justifiable for sovereign and investment grade bonds.

When you get into high yield bonds, there’s a greater chance of losses. But again, they’re manageable and I think it’s a great asset class to be invested in, as I wrote about here: https://cuffelinks.com.au/invest-junk/

Finally, Greek bonds didn’t actually default. They were bailed out because of the commitment of other Eurozone nations to preserving the Eurozone. The bail out is a heavily deferred loan from the EU, so the European entity has accepted what would have otherwise been default losses to investors who had shorter term maturities than the 60 years or so that Greece now has to make payments. But the fact that Greece is part of a group of nations committed to its members in this way is an important part of the risk assessment of Greek bonds.

So, you can’t flippantly dismiss an entire asset class on the basis of one example.

Dudley

August 10, 2019

Into the looking glass:

Greek 10-year yield dips under 2% for first time ever, back below US 10-year
https://www.cnbc.com/2019/07/25/reid-190725-bonds-yields-greece-eu.html

ECB Loads Up Stimulus Salvo as Draghi Laments Worsening Outlook
https://www.bloomberg.com/news/articles/2019-07-25/draghi-signals-worse-and-worse-outlook-warrants-ecb-stimulus

Kevin

August 10, 2019

Amazing that they don’t mention investing in Non bank first mortgage loans that yield from about 5 to 10% pa.

Graham Hand

August 10, 2019

Hi Kevin, this article is specifically about listed securities. Happy to hear about listed securities that invest in first mortgage loans. G

Richard Murphy

August 10, 2019

Hi Graham, thanks for the XTB mention. You note that one loses the diversification of ETFs when you buy individual bonds, just as you do when you buy individual shares.

But to complete the picture: with individual bonds you also retain one of the most critical features of fixed income investments (for many investors), which is the utter predictability of prospective or future returns if you hold fixed rate bonds to maturity – being the prospective Yield to Maturity that Warren explains fully above.

With any perpetual ETF or fund you automatically lose this predictability because putting maturing bonds (the bond feature that delivers predictability) into a perpetual vehicle results in the loss of both income and capital predictability (as bonds are replaced as the mature).

Its why in the US they see bonds held individually, and bonds in funds/ETFs as different (but related) asset classes because the investment outcomes are so different.

Not the case with equity + equity ETFs, which are both perpetual. So ETFs don’t “mirror” owning bonds as they do for equity, currency, commodities. hence US morphing to maturing ETFs.

Depending on the type of investor – this can actually be fundamental to why bonds and the fund/ETFs are not the same thing. For investors like TD investors who are used to and need total predictability, subject only to default, then government bonds/CDIs, and XTBs, and any directly listed bond are the only securities that are predictable in this way on ASX. Hybrids also are, assuming none of the other risks such as income non-payment or call deferral, or conversion occur.

Phil

August 10, 2019

I think you have to take the position that bond funds, as opposed to direct, are long term positions as are equities – that is because they are dynamic and return in the short term difficult to predict ( interest rates, understanding of underlyings, etc etc) I think yield to maturity in isolation could put investors off a potentially sensible investment in their portfolio, that of a defensive ( not necessarily as a return seeking) investment. And that over time, even with rising interest rates ( as managers reset at higher yields) , the bond component will give you Cash + with defensive attributes. But at Yield to Maturity of 1.3%, people will stay away, just as people didn’t want to take 5 year annuities a year or so ago at 4%. Looks ok now.

Richard Murphy

August 10, 2019

Hi Graham, thanks for the XTB mention. You note that one loses the diversification of ETFs when you buy individual bonds, just as you do when you buy individual shares.

But to complete the picture: with individual bonds you also retain one of the most critical features of fixed income investments (for many investors), which is the utter predictability of prospective or future returns if you hold fixed rate bonds to maturity – being the prospective Yield to Maturity that Warren explains fully above.

With any perpetual ETF or fund you automatically lose this predictability because putting maturing bonds (the bond feature that delivers predictability) into a perpetual vehicle results in the loss of both income and capital predictability (as bonds are replaced as the mature).

Its why in the US they see bonds held individually, and bonds in funds/ETFs as different (but related) asset classes because the investment outcomes are so different.

Not the case with equity + equity ETFs, which are both perpetual. So ETFs don’t “mirror” owning bonds as they do for equity, currency, commodities. hence US morphing to maturing ETFs.

Depending on the type of investor – this can actually be fundamental to why bonds and the fund/ETFs are not the same thing. For investors like TD investors who are used to and need total predictability, subject only to default, then government bonds/CDIs, and XTBs, and any directly listed bond are the only securities that are predictable in this way on ASX. Hybrids also are, assuming none of the other risks such as income non-payment or call deferral, or conversion occur.

Warren Bird

August 10, 2019

Valid points, though easy to exaggerate the differences in terms of investment outcomes. I’ve written about this too, here:

https://cuffelinks.com.au/differences-direct-bond-funds/

James

August 10, 2019

I have addressed falling ‘risk free’ returns by adopting a barbell risk approach – keeping 80% in cash and physical gold and taking more risk with 20% in Aussie equities. One thing the GFC highlighted was the importance of diversification, especially credit risk. Innovation and disruption of established industries like banking and healthcare have a long way to go providing some excellent risk reward tradeoffs. Given the downward trajectory of $A, the article makes no attempt to maintain or even enhance the wealth of a global citizen who happens to live in Australia


 

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Firstlinks articles are collected in Pandora, Australia's national archive.

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