Regardless of your investment objectives, financial situation, or prior experience of investing, fixed income ETFs can provide you with a steady income stream to help you meet your long-term investment goals. But to understand the benefits of fixed income ETFs, it’s first necessary to understand the basic principles of fixed income investing.
What is fixed income investing?
Fixed income investments are a key component of effective investment strategies and model portfolios for institutional and personal investors alike. They can provide reliable, steady returns with a lower risk and relative liquidity. Fixed income investing can refer to any financial product that delivers a fixed payout through interest, such as in term deposits with a bank.
One of the most popular methods of fixed income investing is corporate bonds. Bonds effectively act as a loan to the company in question, and generate a regular income for the bond buyer through the bond issuer’s interest payments on the loan.
Buying a company’s bonds rather than buying a stake through shares (also known as equity) is a more reliable investment decision for a number of reasons. The main one is that in the event of a company going into liquidation, bond holders get paid before shareholders.
Bonds, on the other hand, guarantee a certain percentage of the initial investment will be paid at set intervals, usually twice a year. For example, a fixed rate bond with a 5% interest rate would return a ‘coupon’ of $2,500 every six months ($5,000 a year) for a $100,000 investment.
When the bond matures, the bond issuer returns the initial investment in full along with the final interest payment. So in the example above, a three year bond would give a total return of $115,000, meaning a net profit of $15,000.
Fixed interest and floating interest
Different bonds may calculate their interest rates in different ways. Fixed rate bonds provide a set interest rate which, once the bond has been bought, cannot be changed for the entire duration of the bond. This guarantees that no matter what fluctuations occur in the market or general interest rates, the bond buyer will receive the same payout regardless.
A floating rate bond, meanwhile, varies its interest over time in relation to a given benchmark. This benchmark is usually the 90 day Bank Bill Swap Rate, compiled by the AFMA based on the mid-rates of 14 Australian banks. The attraction of a floating rate bond is that it can make use of rising interest rates to provide investors with higher bond yields.
However, the reverse is also true. If the benchmark falls, the floating rate falls too, reducing the bond’s yield. This makes floating rate bonds a much riskier investment than fixed interest bonds, which guarantee a set payout.
Trading fixed income assets
Bonds are relatively liquid thanks to secondary bond markets, where investors can sell their bonds to other investors if they need to raise cash quickly. There is some nuance to this due to the effects of interest rates and credit qualities on a bond’s market price, however.
If the credit quality of the bond issuer rises or falls, the bond’s price on a secondary market will rise and fall alongside it. Likewise, if interest rates are lowered, a bond with a higher interest rate will increase in value as it provides higher-than-average returns; conversely, increasing interest rates will devalue a bond whose interest rate is now outmatched.
Keeping track of a bond portfolio’s worth and knowing when to buy or sell different bonds can therefore be a demanding task. This is where fixed income ETFs come in.
What is a fixed income ETF?
An ETF (Exchange Traded Fund) is a parcel of securities which, like other exchange traded products, can be traded as a single unit in the same way as stocks and shares. This makes them an easy way of creating a diversified portfolio with a single purchase — rather than having to research and buy individual securities, buying into an ETF gives you access to a wide range all at once.
Different ETFs are composed of different securities. An index ETF, for example, is composed of shares in companies across a specific market index and seeks to track that index’s performance, much as index funds do. Other ETFs are built around different asset classes – such as, commodity ETFs, cash ETFs, and fixed income ETFs (also known as bond ETFs).
Rather than buying individual bonds, fixed income ETFs allow investors to build a diverse portfolio of bonds and other debt securities in a single purchase. As with other ETFs, they come in a number of different varieties such as corporate, sovereign and global bond ETFs. Here are the key differences.
- Corporate bond ETFs: Focus on corporate bonds.
- Sovereign bond ETFs: Focus on bonds from national governments, eg. Australian government bonds.
- Global bond ETFs: Seek to track the performance of an international bond index.
What are the advantages of fixed income ETFs?
No matter what category it falls under, an effectively diversified bond ETF remains popular for a number of reasons. First, they are a more stable investment option than individual bonds, as the spread of investments allows the overall value of the ETF to remain high even if individual securities in the fund are devalued.
Another benefit is that bond ETFs provide more frequent payouts than individual bonds. Since they comprise a large number of bonds with coupon payments at different dates, bond ETFs can pay out monthly, compared to the semi-annual payment of an individual bond. This is why it can be popular with income-focused investors.
It’s also easier to trade fixed income ETFs than individual bonds. ETFs are traded daily, this means they can be bought or sold at any time within market hours. This gives bond ETFs good liquidity compared with some single bonds.
Active bond ETFs
If you choose an Active ETF, you can increase your potential return even further. Active ETFs are managed by experienced fund managers, trading the underlying assets more actively in order to beat the performance of the index they’re based on rather than simply matching it. In the case of ETFs based on Australian bonds, this generally means beating the RBA’s cash rate (the interest rate that every bank has to pay on money it borrows).
For example, the eInvest Core Income Fund (Managed Fund) (ASX code ECOR), overseen by experienced investment manager Daintree Capital, is an Australian active ETF with a benchmark target of 2% above the RBA cash rate. This means that investors can aim to receive 2% higher interest rates on their principal with the assurance that their money is under the expert investment stewardship of experienced fund managers.
The return generated through ECOR has seen above average industry results, and provides the suitable platform to a diversified investment portfolio. So, if you are an investor looking for a regular, reliable income with capital security over the short and medium-term, the ECOR product could represent a suitable investment choice.
Bond ETFs vs bond funds
Bond funds are a type of managed fund focusing specifically on bonds and fixed income assets, and are often compared to fixed income ETFs because they are an investment product that works on a similar principle — investors’ money is pooled together to create a fund managed by the issuer to buy bonds and other fixed-income assets, and pay back dividends over time.
However, bond ETFs have distinct advantages over bond funds. Firstly, they offer more trading opportunities – while bond funds are only priced and traded once per day, bond ETFs are given a regularly updated iNAV (indicative net asset value) and can be bought or sold throughout market trading hours.
Bond ETFs can also be more transparent than bond funds — unlike funds, ETFs often reveal their underlying holdings on a daily basis, rather than semi-annually. Early exit fees may also apply to bond funds, meaning you cannot sell them within a certain window without incurring a penalty fee. ETFs don’t charge such a fee, so you’re free to sell them whenever it suits you, giving them greater liquidity.
All things considered, fixed income ETFs make for a popular investment choice. However, as with any investment, they aren’t without risks, the main one being the credit risk – the possibility that the bond issuer will default on bond payments. One way of assessing the risk level of a bond is to check that its credit quality rating meets investment grade.,/p>
Before investing in any financial product, be sure to seek financial advice from a qualified financial adviser, carefully read the product disclosure statement and the provider’s financial services guide, and ensure that you are not investing more than you can afford to lose.
Disclaimer: Please note that these are the views of the writer, Camilla Love of eInvest and is not financial advice. Past performance is not a reliable indicator of future performance.
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