3 Passive Funds for Fixed Income

A raft of tracker funds are available for fixed income investors looking for a simple solution. We look at some options

Jose Garcia Zarate 5 October, 2020 | 11:25AM
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3 passive funds

Whenever we talk about passive funds, and particularly ETFs with their stock-like characteristics, there is a tendency to think about funds that provide access to equity markets. However, one of the fastest-growing segments of the passive industry in the last couple of years has been that of funds offering exposure to the vast array of bond markets. Investors can also benefit from the compounding benefits of the low fees associated with passive funds when thinking about their asset allocation needs in fixed income. Here I outline three interesting options covering a variety of bond markets.

iShares Core UK Gilts ETF

Exposure to government bonds is the core building block of the fixed income portion of a portfolio. Bonds issued by the UK government, commonly known as gilts, fulfil the basic task of providing a counterweight to more volatile equity holdings. The iShares Core UK Gilts ETF is a small and liquid bond market where the opportunities for active managers to add meaningful value are limited. Besides, this is a holding for the long-term, and so the compounding benefits of low management fees trump any other considerations, thus making passive funds the default option.

This ETF is market leader for UK government bond exposure, tracks an index that covers the entire maturity spectrum and comes with a very competitive annual ongoing charge of 0.07%. It currently has a Morningstar Analyst Rating of Gold.

Vanguard UK Investment Grade Bond Index

Corporate bonds typically offer a higher yield than government bonds but expose investors to higher risk as many companies are not as creditworthy as governments; certainly not when pitched against the safest sovereign issuers such as the UK. Still, in the current environment of ultralow rates and given the support of central banks for the economy, demand for corporate bonds has increased significantly.

The Vanguard UK Investment Grade Bond Index fund tracks an index that combines exposure to sterling-denominated bonds issued by companies with investment-grade rating with bonds issued by quasi-government entities (for example, government-backed agencies) and collateralised bonds. Corporate bonds typically represent around 70% of the basket. The 30% in quasi-government and collateralised bonds are notionally less risky than corporate bonds and so help limit overall risk. This better mirrors how the average active manager positions him/herself in this market.

This is a market where experienced active managers have more room to add value, for example via over/under-weighting positions in certain sectors or companies. However, the low cost of the passive fund sets it in good stead to deliver returns above the category average, and on that front this Vanguard fund is competitively priced at 0.12% for its retail share classes. It currently has a Morningstar Analyst Rating of Bronze.

L&G ESG Emerging Market Government Bond USD Index

For the more adventurous. Higher risk but with the potential for a substantial yield pick-up over bond holdings from developed markets. This index fund offers exposure to the market of bonds denominated in US Dollar issued by a broad group of emerging market governments.

The L&G ESG Emerging Market Governmetn Bond USD Index fund has a short track record and it is not currently rated by Morningstar Analysts. However, it is one of the growing number of options available to investors seeking to invest with an ESG lens. The fund tracks the ESG version of the JP Morgan EMBI Global Diversified Index. The index screens the issuing countries on several ESG criteria and gives higher weighting to those who score higher.

Investors have a choice of a share class with returns in USD and in GBP (note, not hedged) for an annual ongoing charge of 0.28%.

L&G also has an ESG-screened index fund that provides exposure to the market of bonds issued in the local currency of emerging market countries. This would be for the even more adventurous, as in addition to the yield pick-up, one may also benefit from any upshot to the exchange rate of those currencies relative to the US dollar, although of course they would also exposed to the risk that these may go in the wrong direction.

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.

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About Author

Jose Garcia Zarate

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