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There are at least three reasons why it may make sense to have some exposure to government bonds in your portfolio. And in this regard, relatively long “duration” government bonds – such as through the newly launched BetaShares Australian Government Bond ETF (ASX Code: AGVT) – potentially offer the most advantageous of these portfolio benefits over time.
1. Superior Credit Quality
Government bonds offer superior credit quality in the Australian bond market, relative to corporate bonds. Indeed, given Australia’s relatively well-functioning economy and low public debt, Australian federal government bonds currently retain the premier AAA global credit rating from all three major credit rating agencies – S&P, Moody’s and Fitch1. State governments also retain very high investment grade ratings.
This means that in times of economic stress, when both equities and corporate bonds could come under market pressure, highly-rated government bond exposures are likely to remain an important “safe-haven” opportunity for investors. It could be said that government bonds are the ultimate “port in a storm!
The BetaShares Australian Government Bond ETF (ASX Code: AGVT) invests in government rather than corporate bonds.
As seen in the chart below, the Index which AGVT aims to track had 53% exposure to Australian (Federal) Government bonds at at 30 June 2019, with remaining exposure spread across State Government and other highly-rated public authorities. As a result, the Index which AGVT aims to track had 86% exposure to AAA-rated bonds.
Sector and Credit Rating Exposure for AGVT’s Index
2. Diversification Alongside Equities
The price sensitivity of fixed-rate bonds to interest rate changes tends to create a handy diversification feature when they’re held alongside equities – namely that their returns have tended to be negatively correlated with equities over the cycle.
Equities tend to fall, for example, when economic conditions weaken, which also tends to be periods when interest rates are falling due to reduced demand for credit and interest rate cuts from the central bank. Falling interest rates, in turn, boost the market value of fixed-rate bonds, as the stream of fixed nominal income payments they offer is worth more in today’s dollars – and vice versa.
This negative correlation tends to be greater, the longer the duration of the bonds in question – as the market value of these bonds is more sensitive to interest rates changes over time. So not only do long duration bonds tend to offer higher income over time than shorter duration bonds, they also tend to have stronger portfolio diversification benefits due to a generally higher negative return correlation with equities.
As seen in the chart below, the Index which AGVT aims to track has tended to provide positive returns in recent periods of significant equity market decline. Not only that, the returns from AGVT’s Index in these negative sharemarket environments have also tended to be stronger than those of Australia’s best-known benchmark bond index, the Bloomberg AusBond Composite – reflecting the fact that the latter has some exposure to corporate bonds and has been of lower overall duration. What’s more, AGVT’s returns have also been higher than the Bloomberg Government Bond Index, reflecting the fact that the bonds in AGVT’s Index tend to be of higher duration.
Bond returns during periods of equity market weakness: 2008 – 2018
Source: Bloomberg. Past performance is not indicative of future performance. Shows performance of index, not ETF, and does not take into account ETF fees and costs. You cannot invest directly in an index.
As might be expected, AGVT’s Index has also produced stronger returns in these periods than long duration corporate bonds – as represented by the index which the CRED ETF aims to track. Not only is CRED’s index made up entirely of corporate bonds, but overall duration is also slightly less than that of AGVT’s Index3.
3. Attractive and Regular Income
Compared to typical cash deposit offerings, Government bonds also tend to offer higher income returns over time. This generally higher income can be considered as compensation for a degree of added price volatility associated with fixed-rate bonds, given their “duration” or price sensitivity to changes in market interest rates over time2. In general, the longer a bond’s duration, the greater its price sensitivity to interest rate changes, and so the higher the income returns it tends to offer over time.
Due to this feature and the diversification benefits described above, AGVT specifically invests in relatively longer duration government bonds – compared to the exposure typically available from other government bond ETFs in the Australian market place that do not have this focus.
Weighted by their issuance value, for example, the average duration of bonds within the Australian government bond market as at June 2019 was 6.1 years, compared with an average of 7.8 years for bonds within the Index which AGVT aims to track.
As seen in the table below, as at 21 June 2019, AGVT’s Index had a yield-to-maturity4 of 1.6%p.a., or around 0.25% to 0.30%p.a. higher than comparable government bond indices.
Portfolio characteristics of Australian Government Bond Indices: as at 15 July 2019
Source: Bloomberg. Past performance is not indicative of future performance. Yield will vary and may be lower at time of investment. Shows performance of index, not ETF, and does not take into account ETF fees and costs. You cannot invest directly in an index.
Conclusion: A Smart Index Approach to Fixed Income
At the heart of AGVT’s attractive risk-return qualities is a smart approach to bond indexing, which has been a feature of all of BetaShares’ highly-rated fixed and floating-rate bond ETFs.
Traditional fixed-income indexing methods in Australia employ what’s known as a “liability weighting” methodology, which primarily weights bonds in an index according to their relative issuance size in the market. This has certain drawbacks, such as the fact that the risk-return characteristics of these indices can change over time depending on the nature of bond issuance in the market.
By contrast, BetaShares adopts indexing strategies that explicitly target certain types of risk and return characteristics (or “risk premia”) available in the market – such as duration (or sensitivity to interest rates) and credit (or sensitivity to credit spreads). The Index which AGVT aims to track, for example, focuses on a particular duration (7-12 years) rather than letting duration be dictated by the idiosyncratic issuance patterns of the Australian government bond market.
As seen in the diagram below, our aim is to provide the bond “building blocks” that enable investors to mix and match bond exposures so as to get the risk-return characteristics they desire.
Risk vs return characteristics of BetaShares’ Cash, Bond and Hybrid Fund exposures
1. As at 30 June 2019. Credit ratings reflect the opinions of particular ratings agencies, and do not provide any assurance regarding the bond issuer’s ability to meet its payment obligations in relation to a bond. Credit ratings are not intended to be an investment recommendation or used as a basis for assessing investment merit. They are limited in scope and may be changed or withdrawn at any time.
2. Duration (or more specifically “modified duration”) is a summary measure of the price sensitivity of a bond, or bond index, to changes in the general level of interest rates, which, in the case of fixed-rate bonds, is closely linked to their remaining term to maturity. A modified duration of 5 years, for example, would indicate that the price return of the bond or bond index would decline by around 5% for every 1 percentage point change in interest rates. Financial markets usually reward bonds with a higher price sensitivity to interest rates with a higher yield, due to their likely greater return volatility – as a standalone investment – over time.
3. That said, despite the higher corporate bond exposure of CRED’s index, it nonetheless mostly outperformed the AusBond Composite Index in these periods as it holds longer duration bonds which benefit more when interest rates decline.
4. Yield-to-maturity is the purest measure of expected long-run income returns from a fixed-rate bond, as it captures the effective yield an investor would earn if the bond were purchased today, held till its maturity, and the principal (or “par value”) of the bond were returned at maturity. A similar concept is running yield, which measures income returns over the coming year divided by the bond’s current market price. Running yield is an indicator of short-run income returns, but does not allow for potential long-run capital losses (gains) at maturity if the bond’s market price is significantly higher (lower) than it’s par value. With declining interest rates in recent years, for example, the market value of many bonds has increased relative to their par or maturity value – implying future capital losses if these bonds are held till maturity. This has led to the running yield on many bonds – and bond indices – being somewhat higher than their yield-to-maturity, thereby potentially overstating their long-run likely return.