Blending fixed income ETFs for efficient outcomes
Exposure to credit and duration
A blend of AGVT/CRED/QPON provides exposure to both credit and duration, compared to futures-based fixed income exposures, which are primarily dependent on duration
|A blend of the indices which AGVT/CRED/QPON aim to track outperformed the AusBond Composite index by 0.68% p.a. over the last 11 years*||
Management fees of 0.22% p.a. (AGVT), 0.25% p.a. (CRED) and 0.22% p.a. (QPON)
Institutional use of ETFs around the world is on the rise – and at the forefront of this increased usage is widespread adoption of fixed income ETFs.
A 2019 study by Greenwich Associates1 found that US institutions are using ETFs as a mainstream and even primary means of gaining exposure in their fixed income portfolios. 60% of study participants reported investing in bond ETFs in 2018, up from 20% in 2017, while 41% of participants said they planned to increase their allocation to bond ETFs in the next year.
As a result of increasing allocations, ETFs in 2018 accounted for around 29% of total fixed income assets by US institutions, up from 20% in 2017.
As a vehicle for attaining bond exposures, ETFs were second only to individual bonds (which 65% of participants reported using) – and well ahead of active mutual funds and separate/managed accounts.
North of the border the same scenario is playing out, with a study of Canadian institutions finding 69% of study participants used bond ETFs in 2017, and Canadian asset managers and institutional funds invested almost 20% of total fixed-income assets in ETFs2.
The increasing adoption of fixed income ETFs has been mirrored in Asia, where a surge in use is one of the primary drivers of ETF growth in the region.
Why are institutions turning to bond ETFs?
Among the reasons institutions gave for using bond ETFs were:
- ease of use
- quick access
- low costs (both management fees and trading costs), and
- single-trade diversification.
Reasons for using Bond ETFs
Note: Based on 108 respondents.
Source: Greenwich Associates 2018 U.S. Exchange-Traded Funds Study
Greenwich’s Canadian study found that more than half of institutional futures users reported replacing a futures position with an ETF over the previous 12 months – primarily to benefit from ETFs’ operational simplicity and lower roll costs.
Using ETFs to track the AusBond Composite
Many Australian institutions are looking for their fixed income exposures to track the performance of the Bloomberg AusBond Composite 0+ Yr Index.
A common way to do this is to use a mix of 3-year and 10-year bond futures.
However, we believe that a combination of fixed income ETFs offers several benefits over the use of futures.
More efficient exposure
Returns from fixed income are primarily a product of two components: duration and credit.
The AusBond Composite includes fixed income securities issued by government and semi-government entities, supranational and sovereign entities, and corporations.
Its returns are therefore derived from both duration and credit. Both government and corporate securities are a source of duration, while the corporate component is the primary source of credit returns.
Using bond futures to achieve fixed income exposure essentially ignores credit as a source of return, and ties returns almost entirely to the duration component (plus an element of roll return). It removes the non-Government component of the AusBond Composite, introducing tracking error into the mix.
We believe a better alternative is to use three of our fixed income ETFs:
- The BetaShares Australian Government Bond ETF (ASX: AGVT) provides exposure to AUD-denominated fixed rate bonds issued primarily by Australian federal and state governments, and with a component issued by supranationals, sovereign agencies and similar issuers.
- The BetaShares Australian Investment Grade Corporate Bond ETF (ASX: CRED) provides exposure to a portfolio of investment grade fixed-rate Australian corporate bonds.
- The BetaShares Australian Bank Senior Floating Rate Bond ETF (ASX: QPON) provides exposure to a portfolio of some of the largest and most liquid senior floating rate bonds issued by Australian banks.
AGVT can be used as a proxy for the government bond component of the AusBond, and CRED for the corporate bond component.
Because the modified durations of both CRED (6.1 years as at 31 July 2019) and AGVT (7.81 years as at 31 July 2019) exceed the duration of the AusBond Composite (5.38 years as at 31 July 2019), investors looking to match the duration of the AusBond Composite index can include an exposure to QPON (0.10 years as at 31 July 2019) to dial back the overall duration of a portfolio of the three ETFs.
The table below shows the modified duration and yield to maturity of a blend of the three fixed income ETFs (30% AGVT/49% CRED/21% QPON), against the duration and YTM of the AusBond Composite as at 31 July 2019.
|Modified duration (years)||Yield to maturity
Yield will vary. Not indicative of future yields. Illustration only. Not a recommendation to adopt any particular investment strategy.
Potential to outperform
A blend of the three fixed income ETFs offers the potential to outperform not only a fixed income exposure through 3-year and 1-year bond futures, but also, as the table above shows, the AusBond Composite itself.
The potential to outperform a bond futures exposure is a result of the ETFs’ exposure to the credit source of returns. The yields available from the corporate bonds in CRED’s and QPON’s portfolios will typically exceed the returns from the government bonds that the futures contracts are based on, reflecting the credit spread between the two bond types.
The blend also has the potential to outperform the AusBond Composite. As at 31 July 2019, the AGVT/CRED/QPON indices blend offered a yield to maturity 0.71% p.a. higher than the AusBond Composite – despite the fact that portfolio duration in the blend is identical3.
As the chart below shows, a blend of AGVT/CRED/QPON, rebalanced annually to reset the portfolio’s modified duration to match that of the AusBond Composite4, produced higher returns than a 100% allocation to the AusBond Composite index for a range of periods over the last 11 years. The annualised return from 1 April 2008 to 31 July 2019 for the blend was 7.02% compared to a return of 6.34% for the AusBond Composite5.
Source: Morningstar Direct. Illustration only. Not a recommendation to adopt any particular investment strategy. Shows performance of indices in combination, not ETFs, and does not take into account ETFs’ fees and costs. Past performance is not indicative of future performance. You cannot invest directly in an index.
Volatility was comparable at 2.81% p.a. for the AGVT/CRED/QPON index combination over the 11 years vs. 2.88% p.a. for the AusBond Composite. The AGVT/CRED/QPON index combination produced a superior risk-adjusted return (Sharpe ratio of 1.34 vs. 1.09 for the AusBond Composite)6.
Flexibility to fine-tune exposure
One of the advantages of using several ETFs, each offering a focused exposure to a distinct and well-defined sector of the fixed income asset class, is that an institution can tailor its overall exposure to its particular requirements.
For example, if an institution wants to adjust the balance of its duration/credit exposure more towards duration, it could increase its weighting to AGVT.
If, on the other hand, it wants to increase its exposure to credit, it could adjust weightings more in favour of CRED.
Similarly, an investor looking to dial back overall duration could increase its allocation to QPON.
Using a combination of ETFs to gain fixed income exposure can offer benefits over both an investment that tracks the AusBond Composite Index, and an approach employing 3- and 10-year futures.
There are risks associated with investing in the Funds, including interest rate risk, credit risk and index tracking risk. The value of an investment and income distributions can go down as well as up. Before making an investment decision investors should consider the relevant PDS and their particular circumstances, including their tolerance for risk, and obtain financial advice.
*Illustration only. Not a recommendation to adopt any particular investment strategy. Past performance is not indicative of future performance.
1. Greenwich Associates, U.S. Institutions’ New Tool of Choice for Portfolio Construction, 2019
2. Greenwich Associates, Canadian Institutions Lead the Way in ETF Investing, 2018
3. Yield will vary. Not indicative of future yields.
4. At the end of each calendar year the portfolio is rebalanced by:
- allocating to AGVT 40% of the total weighting of federal and state government bonds in the Ausbond Composite, and
- splitting the remaining available weight between CRED and QPON so that the overall portfolio duration matches that of the Ausbond Composite
5. Source: Morningstar Direct
6 Source: Morningstar Direct