A Smarter Way To Invest In Bonds

Bonds are an effective hedge against equity market volatility, and they should always have a place in a well-diversified portfolio.

Bond ETFs offer investors the benefits of a smaller capital outlay, greater diversification, higher liquidity and clearer price transparency, as opposed to direct bonds.

Having considered the various pros & cons of investing in direct bonds, bond ETFs and bond UTs, we find that bond ETFs are generally better instruments to use when investing in bonds, especially investment grade bonds.

With less than USD 350, investors can construct a diversified bond portfolio with just two ETFs – Vanguard Total International Bond Index Fund ETF and iShares Core US Aggregate Bond ETF.

The Importance Of Bonds Within A Portfolio

A well-diversified portfolio should contain both equities and bonds. While bonds have historically delivered lower returns compared to equities (Chart 1), it remains an indispensable part of our portfolios. Their relatively lower volatility means that bonds are an effective hedge against equity market volatility.

Chart 1: Bonds Provide A Hedge Against Equity Volatility Especially During Severe Market Downturns

What Is A Bond ETF?

A bond ETF holds a basket of bonds that is designed to replicate the returns of a specific index, similar to equity ETFs like the STI ETF. However, unlike most bonds which trade over the counter (OTC), a bond ETF is traded like stocks on an exchange.

While it is common for equity ETFs to hold all the securities in its underlying index according to their respective weights (known as full replication), this is tougher to achieve with bond ETFs. Due to the sheer number of issues within an index and the illiquid nature of bonds, bond ETFs normally hold only a portion of all the bonds in the index, a process known as representative sampling, which saves on trading costs and avoids the liquidity problem, although it may introduce tracking difference.

There is a broad range of bond ETFs, each designed to target a different segment of the global bond market. They can be broadly classified based on: credit rating (investment-grade vs high-yield) and issuer type (sovereign vs corporates).

The Benefits Of Investing In Bond ETFs

Low initial capital outlay: The minimum sum required to invest in a corporate bond in Singapore is typically SGD 250,000, which is out of reach for most retail investors. However, with bond ETFs, you can start with as little as SGD 100.

Greater diversification: Through a bond ETF, investors can access many bonds that are diversified across different sectors, credit ratings and maturities at minimal cost. An investor investing in individual bonds will have to fork out a huge capital to achieve the same level of diversification with bond ETFs. Also, a single default within a bond ETF will not have a major impact on your overall investment as each bond ETF holds hundreds if not thousands of bonds but the default of an individual bond is likely to have dire consequences.

Liquidity & transparency: Most bonds trade over the counter (OTC) instead of on an exchange. ETFs are exchange traded where there are many other investors and market makers who provide ample liquidity to the market.

Another problem associated with non-exchange traded products is that there is no “official agreed upon price”. Thus, brokers have the flexibility to quote different prices, often with high mark-ups. This causes the bonds to have wider bid-ask spreads and reduces returns.

Costs: Cost is a key advantage for a bond ETF over a bond UT. The average bond ETF has an annual expense ratio of 0.3% compared to 1.03% for a bond UT. Over an extended holding period for long term investors, this cost difference can have a significant impact to an investor’s total returns over the same period.

For more information of how expense ratios can erode returns, check out the article below:

Related Article: ETF Focus List: Top ETFs For Your Portfolio

Pros & Cons Of Investing In A Bond, Bond ETF And Bond UT

We summarise the pros and cons of investing in an individual bond, a bond ETF and a bond UT in the table below.

Table 1: Bond ETFs Score Better Aganist Individual Bonds and Bond UTs

Having considered the various pros & cons of investing in individual bonds, bond ETFs and bond UTs, we find that bond ETFs are generally better instruments for retail investors as it allows for a smaller capital outlay, has lower expense ratios, better liquidity and are easier to trade.

How to Select a Bond ETF?

1. Credit Rating

The credit rating of a bond ETF is important because it reflects the overall risk profile of the ETF and the interest investors will receive.

Investment-grade bond ETFs invest mainly in bonds that carry a credit rating of BBB- or higher, based on Standard & Poor’s rating system. These investment-grade bonds pay lower coupons, are usually issued by corporations or governments with strong capacity to meet financial obligations, and are less likely to default.

High-yield bond ETFs focus mainly on high-yield bonds, also known as non-investment grade bonds or ‘junk’ bonds, which carry a credit rating of BBB- or lower. These bonds are issued by governments or organisations that have weaker financial positions, are more susceptible to defaults and hence, are considered riskier investments relative to investment-grade bond ETFs. However, they pay higher coupons to compensate investors for taking on additional credit risks.

The average credit rating of an ETF is one of the most important factors one should consider before investing in an ETF. While the higher level of returns provided by high-yield bonds can be tempting, taking on excessive risks can also cause investors to lose a valuable portion of their nest eggs. Needless to say, novice or risk-averse investors should ideally obtain their bond exposure using investment-grade bond ETFs, and limit their exposure to high-yield bonds.

In general when it comes to investment-grade bonds, ETFs are suitable instruments as the underlying bonds are generally safe and require minimal management oversight. In contrast, unit trusts are better instruments when it comes to high-yield bonds. As high-yield bonds carry higher risks relative to investment-grade bonds, it is prudent to have a professional manager present to decide which high-yield bonds should be included in the fund. A high-yield bond ETF will simply track the performance of the underlying index, with no discretionary management involved to sieve out the better ones.

2. Issuer Type

Besides credit rating, bond ETFs can also be classified based on issuer type.

Government bond ETFs invest mainly in sovereigns bonds, which are debt securities issued and backed by governments, such as the Singapore Government Securities (SGS). While sovereigns are generally considered safe investments, they are not completely risk-free, as countries such as Russia and Greece have historically defaulted on their debt obligations.

Quasi-Government bond ETFs invest in are bonds issued by government-related entities such as the Land Transport Authority (LTA) in Singapore and Fannie Mae (Federal National Mortgage Association) in the US. These bonds also typically have low default rates, and while they are not backed by national governments, investors often perceive an implicit guarantee.

Corporate bond ETFs invest in bonds issued by companies to raise capital for business purposes. They typically pay higher coupons than sovereign bonds as they are relatively riskier.

Here's How You Can Get Started

For investors who are new to bonds, here’s a piece of good news: it’s not at all difficult to get started on bond investing. With as little as two ETFs, investors can obtain diversified exposure to global bond markets.

The Vanguard Total International Bond Index Fund ETF (NASDAQ.BNDX) combines over 4,800 investment-grade bonds across the globe (excluding US) issued by various governments, government agencies and corporates. This ETF has an average investment-grade credit rating of AA and an expense ratio of only 0.11%.

The iShares Core US Aggregate Bond ETF (NYSE.AGG), which is composed of over 6,700 US investment-grade bonds, is a good complement to the Vanguard Total International Bond Index Fund ETF. Close to 40% of this ETF is made up of US treasury bills, and other top ten holdings include issuers such as Fannie Mae and JP Morgan. Along with its AAA investment-grade credit rating, this ETF also boasts a low expense ratio of 0.05%.

This sample portfolio (constructed using 4 lots of the Vanguard Total International Bond Index Fund ETF and 1 lot of the iShares Core US Aggregate Bond ETF) sets you back USD 322 (based on 16 July 2018 prices), but it gives you a globally diversified portfolio of bonds with a 33% allocation to the US and 67% to the rest of the world (Chart 2).

Not everything is as easy as it seems, but when it comes to bond investing, it is as simple as it is ingenious. With just two ETFs and an initial capital outlay of less than USD 350, one can already construct a well-diversified portfolio of bonds representative of the global bond market, while incurring an average expense ratio of only 0.08%.

Chart 2: For Less Than USD 350, You Can Construct A Globally Diversified Bond Portfolio

In the recent years where we have seen several local companies default on their bonds, the importance of diversification and strong credit ratings cannot be understated. For new investors who want exposure to bonds, investing in a portfolio of investment-grade bond ETFs is a simple and easy way to start.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.