Until bond ETFs became common a few years ago, putting together a diversified bond strategy was complicated. The bond market is varied, made up of both government bonds and corporate bonds. Thanks to ETFs, investors can take advantage of low-cost bond investments in a transparent, straightforward way.
At Moneyfarm, choosing the right ETFs is one of our primary roles as a wealth manager. It’s a key part of the development of investment strategies in passive funds. In this article, we’ve put together a complete guide on how to select bond ETFs and highlighted some of the best instruments listed on the stock exchange.
How does a bond ETF work?
Bond ETFs are exchange-traded funds that track a bond index and try to replicate the returns. Although these instruments contain bonds, they are traded on the stock exchange as shares, so they have some attractive properties for investors.
Typically, equity ETFs are made up of all the stocks in their benchmark index – this is usually not possible with bonds. Bond indices often include hundreds, even thousands, of individual stocks. Buying all those bonds for an ETF’s portfolio would not just be difficult but expensive. The cost of buying thousands of bonds in illiquid markets, even those with a minimal impact on the index, can quickly erode returns.
So, fund managers choose a selection of the bonds on the bond index to be included in the ETF. These are bonds that give the best representation of the index, based on credit quality, exposure, correlations, duration, and risk.
This process is called optimisation. Optimisation cuts down on costs but comes with its own risks. Various optimisation strategies could cause the performance of an ETF to deviate from that of its index, for one. Because of this, the ETF selection process is more complex than it is for, say, equity ETFs. In most cases, it’s best left to a professional.
The differences between investing in bonds and bond ETFs
There are a few core differences between investing in a bond ETF and buying a bond.
Bond ETFs do not mature
Individual bonds have a fixed, invariable date on which they mature and investors receive their invested capital back. Bond ETFs, on the other hand, maintain a constant maturity. However, the bonds that make up the ETF could expire or leave the ETF’s remit at any point.
For example, let’s imagine a long-term BTP ETF that excludes all bonds that are approaching maturity beyond a certain threshold. As a result, additional bonds are continually bought and sold to keep the duration constant of the wallet. This process, called ‘rollover’, means that the stocks that make up the ETFs change continuously. This means that the price of an index can go up or down depending on the current composition of the portfolio.
There are different types of rollover strategies
Some rollover strategies are mostly automated, while others leave it to the manager to carry out optimisations. Choosing the rollover and optimisation strategies adds an additional layer of complexity to the process of building a portfolio of bond ETFs.
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Bond ETFs are comparatively liquid
Not all bonds are traded daily. Bond ETFs, however, are traded on an exchange, which means they can be bought and sold at any time during market hours, even if the underlying bonds are not traded at that time.
The price of ETFs is updated daily
This means that, in the event of a rate increase, the value of your ETF portfolio could devalue. This wouldn’t happen if you bought individual bonds held to maturity. Ultimately, the changing price reflects the current market value of the instrument. Continuous updating has important consequences from a fiscal point of view, because any appreciation or devaluation of the portfolio generates a capital gain.
Advantages of bond ETFs
- Diversification: An ETF gives investors thousands of securities, which significantly reduces credit risk, i.e. the risk of the security issuer defaulting
- Flexibility: Being quickly exposed to a large number of different markets and factors adds a huge degree of flexibility
- Convenience: Bond ETFs are a particularly efficient solution for exposure to the bond market
The best bond ETFs for 2020
Bonds vary greatly in terms of the type of instruments they use. Putting together a bond that successfully mitigates risk and is positioned to generate strong returns is not easy.
The first step in building a bond strategy is to properly identify your objectives. Once you’ve done this, you can find bonds with the right balance of duration, coupon flow to be included in your portfolio.
Next, we have the fund selection phase. This is where you pick the best bond ETFs in each category: whether it be a global bond, a corporate bond or an Emerging Market Bond. At Moneyfarm, we employ a rigorous selection process to pick the best fund for each category. We use a score that rewards the most traded, cheapest bond ETFs listed on the stock exchange and certain types of rollover and optimisation. Here are some of the funds we’ve selected for some of the most popular bond categories.
Global bond ETF on government bonds
In this category, the fund we have chosen is Xtrackers II Global Government Bond UCITS ETF a product that stands out for its size and the quality of the issuer.
Emerging market bond ETFs (government bonds)
With regard to ETFs on bonds from emerging countries, we’ve picked iShares J.P. Morgan USD EM Bond UCITS ETF and SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF. Both stand out for their long history and the large market for both ETFs.
High Yield Corporate Bond ETFs
For this category, we have selected iShares Global High Yield Corp Bond UCITS ETF. This ETF tracks the underlying index particularly well.