ETFs make bonds more accessible to Australian investors

If there is one important asset class that Australians are short of, it would have to be bonds.

While bonds are central parts to an investment portfolio in other parts of the world, many Australians have historically simply used cash as a proxy for bonds.

That can be a dangerous assumption because cash can behave very differently to bonds, with inflation eating into and at times neutralising the real return on cash while bonds are capable of producing handsome capital gains when interest rates fall.

There are also important practical and historical reasons why bonds have been less popular with small investors, due to the need for a large amount of capital, the patience needed to sit out lengthy maturation and the inability to get meaningful diversification across a range of bond yields and maturities.

The rise of ETFs in bond investing

That has all begun to change now that exchange traded funds (ETFs) are offering bond funds that provide diversification and ease of entry, alongside the many active bond funds that are also available.

With interest rates having rising quite dramatically – and, it should be noted, producing sharply negative returns for many bond holders and funds in the process – we could be about to enter a new sweet spot for bond investment.

That is certainly beginning to show up in the figures with fixed income (including government, semi-government, bank and corporate bonds) accounting for a healthy 17.9% of the $150 billion in ETFs at the end of June.

Cash and fixed interest ETFs have experienced significant inflows over the past year, while equity-focused ETFs have seen much slower growth

Less volatility and correlation

Traditionally, bond returns often go up when the return on shares is going down, although bonds had a terrible year last year as the quickfire rise in official interest rates around the world inflicted heavy capital losses on those holding existing bonds with lower interest rates.

That poor performance – which Vanguard said was the worst year for bonds since 1842 – could be about to turn around as many central banks including the RBA get close to reaching a peak in official interest rates and might even start to cut rates if economic growth begins to drop too low or turn negative.

Benefits of investing in bonds

Apart from the potential timing benefits of investing in bonds, there are also other benefits, with bond cash-flow well understood and virtually guaranteed so there is much less uncertainty about bond pricing compared to shares.

As the fixed income term correctly implies, those cash flows are often paid quarterly and knowing those reliable and regular payments will arrive adds a layer of safety for investors compared with the less reliable and less regular dividend flows from shares and even term deposits.

Bonds can offer more inflation protection than cash term deposits too, which helps to preserve spending power.

As you might expect for a booming area, there are a lot of bond and fixed interest ETFs on offer.

How to select a bond ETF

Selecting one is largely a matter of choosing what you want, with the most secure being those that mostly invest in AAA rated government bonds with the risk and the yield generally increasing slightly as you move down to corporate bonds and banks hybrids.

The other thing to watch is that most of the government bond ETFs pay interest quarterly while some of the corporate and floating rate bond funds pay monthly.

Some of the more popular include: iShares Core Composite Bond ETF (ASX: IAF), Vanguard Australian Fixed Interest Index ETF (ASX:VAF), SPDR Australian Government Bond Fund (ASX: GOVT), Betashares Australian Investment Grade Corporate Bond ETF (ASX: CRED) and Betashares Australian Bank Senior Floating Rate Bond ETF (ASX: QPON).