ETFs open up corporate bond market

The corporate bond market in Australia is much bigger than people think. While ETFs (exchange traded funds) have enabled investors to more easily access bond market exposures, many Australian self-managed superannuation fund portfolios remain overloaded with cash, shares and property and are more risky than people realise. One way to curb this investment risk is to diversify into corporate bonds.

Companies can raise money by issuing equity (shares) or issuing debt in the form of bonds. The company issues bonds in return for a loan from investors. Corporate bonds are like government bonds in that they pay regular coupons or interest payments and at a set maturity date repay the principal amount invested. The main difference is that they are issued by companies rather than governments, so they are more risky, relying on the company’s commercial success rather than the government’s treasury.

However, corporate bonds are considered less risky than shares as the bond issuer promises to repay the principal at the end of the term and if the issuer becomes insolvent, bond holders are repaid in priority to shareholders. The tradeoff is that bond holders do not share in the profits of the company like shareholders do. The benefit is that they are not exposed to the same risk of losing capital that shareholders face. This can make bonds a relatively more defensive investment than shares.

Yet private investors hold few bonds, owning less than 1 per cent of all corporate bonds on issue in Australia compared to almost 20 per cent in the US. Institutional investors too are relatively underweight corporate bonds. Australian superannuation funds hold only 10 per cent of their assets in bonds and bank bills compared to an OECD average of 40 per cent, according to Deloitte Access Economics' report, The Corporate Bond Report 2018: Australia's Growing Appetite for Corporate Bonds.

So there is much potential for greater local ownership – and ETFs are boosting this potential.

Bond markets historically inaccessible

Much of investors' lack of interest in corporate bonds has been due to their inaccessibility. Unlike equities, most bonds are traded in the "over-the-counter" market, directly between large institutional investors. There is no bond exchange equivalent of a stock exchange and so the OTC market lacks transparency. Minimum investment sizes are large and few brokers offer bond trading facilities to retail investors, unlike the many online brokers that are available for retail investors to easily trade shares in smaller dollar amounts. As a result, corporate bonds investors are mostly held by institutions.

Other barriers to investment have included a lack of awareness of bonds' benefits. This was identified by 38 per cent of respondents to a recent survey conducted by Deloitte Access Economics of investors who did not own bonds. Furthermore, almost 70 per cent of those non-investors said that they had insufficient understanding to invest in corporate bonds.

This is exacerbated by the difficult relationship between bond prices and interest rates, which move in opposite directions. So as interest rates rise, bond prices tend to fall and their value can therefore be eroded in a rising rate environment.

Benefits of bonds

Yet bonds hold many benefits. They are relatively defensive investments which means they may do well when the economy slows down or equity markets sell off. Some high quality fixed-rate corporate bonds have provided comparable, and in some cases, better returns compared to Australian and international shares.

Over 10 years to 30 June 2018, the return on corporate bonds outstripped the return on the S&P/ASX 200 Accumulation Index, which returned 6.40 per cent a year. Over the same period, corporate bonds, as measured by the Bloomberg AusBond Credit 0+ Yr Index, gained 6.65 per cent a year.

Asset class returns 1998 to 2108. Source: Bloomberg as at 30 June 2018

The graph below shows the strong outperformance of Australian bonds during the global financial crisis compared to equities.  Corporate bonds easily outperformed Australian equities during 2008 when the GFC in 2008 and in 2011, which was marked by high levels of equity market volatility. 

Source: Morningstar Direct. You cannot invest in an index. Past performance is not a reliable indicator of future performance 

During the GFC, bonds did a lot better than Australian equities, which took almost six years to recover. Bonds withstood the assault and came out post the GFC performing much better.

ETFs: opening up investment options

While the corporate bond market was previously difficult to access, ETFs have opened up the market to all types of investors. Because ETFs are traded on the ASX, investors can easily buy and sell in amounts that suit their individual investment needs. Compared to unlisted managed funds, ETFs also provide more transparency in terms of their holdings and are generally more liquid and lower cost.

ETFs that track a well-diversified bond index offer instant diversification in a single trade for ASX-investors. However, to understand the quality of a corporate bond ETF, it is key that investors look under the bonnet of the fund to understand the index and further still the investment strategy that the ETF manager is using to track the index.

Key things to look for are the credit quality of bonds in the index and the diversification of issuers.

The quality of a bond is determined by its credit rating. A bond and its issuer usually carry a credit rating determined by independent ratings agencies which give an indication of how risky the issuer and therefore its bonds are, that is, an assessment of the risk that the issuer will not be able to pay coupons or the principal when they are due. If a bond has a high credit rating within a band called "investment grade", it is considered to be safer. Sub-investment grade bonds are considered to be more risky. The yields on low rated bonds are therefore higher than the yields on safer, higher rated bonds.

Other things for investors to consider are the type of bonds in which an ETF invests. Bond indices may include a variety of bonds such as government bonds, semi-government bonds, corporate bonds, floating rate bonds, inflation-linked bonds or offshore bonds, or a combination of these. A range of fixed-income ETFs are available to investors.

VanEck's bond ETF options

VanEck has two fixed income ETFs on the ASX which can provide portfolio diversification solutions. VanEck Vectors Australian Corporate Bond Plus ETF (PLUS) and VanEck Vectors Australian Floating Rate ETF (FLOT).

FLOT tracks the market benchmark for all Australian floating rate notes (FRNs), the Bloomberg AusBond Credit FRN 0+ Yr Index. FLOT currently offers a higher yield than cash and term deposits. As the coupons from a floating rate note rise with interest rates, interest rate risk from rising rates is reduced.

Moving slightly up the risk spectrum, investors can earn potentially higher with the VanEck Vectors Australian Corporate Bond ETF (PLUS). PLUS is a portfolio of the highest yielding predominantly investment grade corporate bonds on offer in Australia. The ETF aims to track the Markit iBoxx AUD Corporates Yield Plus Index, which is designed to reflect the performance of the 50 per cent highest-yielding AUD denominated corporate bonds with credit ratings from AAA to BB-. Investment grade bonds must make up at least 80 per cent of the portfolio.

Depending on the ETF investment, there will be risks that investors need to consider that may affect the value of their investment or their return. Investors should speak to their financial adviser or stockbroker and read the ETF's product disclosure statement to investigate the benefits and risks before making an investment decision.

More from Morningstar

• Bank-owned super funds face new legal threat

• CKI's bid for APA unlikely to succeed: Morningstar

• Make better investment decisions with Morningstar Premium | Free 4-week trial

Arian Neiron is the managing director and head of Asia Pacific at ETF provider VanEck. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.