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Bond ETFs for Income at a Low Cost

Tracking a bond index can be more complicated than following a stock market, but demand for fixed income ETFs is growing rapidly, not least because of their low charges

Jose Garcia Zarate 14 November, 2019 | 1:07PM

bonds

The popularity of passive investing continues apace and one of the key areas of growth is fixed income. Inflows into bond ETFs and index funds in the first nine months of 2019 amounted to around £55.7 billion, more than doubling the new money allocated to equity passive funds.

In the choice between exchange-traded funds (ETFs) and traditional index funds the ETF wrapper is streets ahead, having captured around two-thirds of the new money into passive bond funds.

Barring a sea-change in market conditions in the fourth quarter, 2019 will be a bumper year for bond passive funds. Speaking to ETF providers, it is apparent that fixed income is a key strategic area of growth for the industry over the coming decade.

This will only add more fuel to the ongoing debate of whether tracking an index is the right way of gaining access to bond markets. Critics of passive investing are always ready to argue that bond indices are inherently flawed. In particular they point to the concept of market-cap weighting – this is where you construct a portfolio so that the larger a holding, the more assets are assigned to it, meaning you become skewed to bigger stocks. It works well for equity markets but, some say, is not a good idea for bond funds.

The idea of assigning larger weightings in a portfolio to the larger debtors is not intuitively appealing. And yet, adopting a negative view about a bond issuer (for example, a government) purely on the basis of the amount of debt it has issued, is not the most rational way of going about things either. Bond markets are complex and, ultimately, what should matter to investors is the ability of the bond issuer to repay its debts.

Take the case of Japan, the developed country with the highest public debt burden in the world at almost 240% of its GDP, or the US with a public debt-to-GDP ratio of around 105%. These two countries regularly have a very large presence in global government bond indices constructed using standard market-cap weighting. Does anybody seriously doubt the ability of the Japanese or the US governments to pay their debts back? This is not to say that market-cap bond indices are ideal, but it shows that just focusing on absolute debt ratios to criticise them is a simplistic argument.

In any case, it is important to note that most of the bond indices tracked by ETFs and index funds are not pure market-cap weighted. This is particularly the case in areas of the bond market such as corporate bonds and emerging market governments, which are riskier than developed governments.

Indices for these riskier areas typically apply liquidity filters and impose caps at single issuer level to avoid becoming too concentrated. These are safety measures designed to ensure diversification of risk while aiding passive bond fund managers in the task of replicating the performance of the index.

Adding Value

The trade-off of placing these restrictions when constructing corporate or emerging market bond indices is that you end up excluding segments of these markets that may not be as liquid but nonetheless could be good opportunities. This means that experienced active bond fund managers could fish into these areas neglected by the indices to add value; it's something that Morningstar analysts readily acknowledge when issuing our Analyst Ratings.

However, whether active managers are able to add value consistently over the long-term is debatable. Aside from the mistakes that they may end up making in their selection, active bond fund managers also must overcome a very important advantage of passive funds, namely their low cost.

And when it comes to cost, the odds are only increasing in favour of passives. For some years now there has been a “fee war” among passive fund providers. Initially the fee cutting drive was almost exclusively focused on equity ETFs and index funds, but it has now spilled over to bond passive funds.

Just a few weeks ago we saw Vanguard cut fees for several of its bond index funds and a number of ETF providers have also reduced their charnges. Investors in Europe can now access mainstream government bond market ETFs with single-digit ongoing charges. And the downward pressure on fees is extending also to areas such as corporate and emerging market debt.

For example, UK investors looking for a long-term holding in UK government bonds – the bread and butter of bond allocation – are unlikely to go wrong with a passive fund. This is a case where keeping a tight rein on costs should be the number one objective, as the opportunity set for active managers to add value is rather limited. The obvious choice here is to go with a tracker. The long-running iShares Core UK Gilts ETF – the market leader in this segment – now comes with an ongoing charge of 0.07%, while Invesco UK Gilts ETF, launched in March 2019, charges 0.06%.

Overall, there may not be such thing as a flawless passive bond fund. However, the combination of affording very easy access to all corners of the bond market and their low – in fact, increasingly lower – cost is likely to ensure a good future for bond passive funds in the years ahead.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Jose Garcia Zarate

Jose Garcia Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe

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