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According to a Bloomberg report from June 2019, more than 20% (or US$11 trillion worth) of the investment-grade bonds on issue worldwide were trading at negative yields. In other words, investors buying these bonds know that if they hold them to maturity, they will receive cashflows over the life of the bond that are less than what they are paying for the bond today!
While we have not yet reached that point in Australia, interest rates are at record lows after the RBA cut the cash rate in June and again in July 2019. For investors seeking income, this presents a significant challenge. What are your options?
In Part 1 of Investing for income in a low-yield world, we look at opportunities in the cash and fixed income asset class. In Part 2, we will explore the opportunities to earn income from equities.
All investments involve a trade-off between risk and return.
Cash is regarded as risk-free. With term deposits offering historically low rates, and often requiring you to tie your money up for months, one option is an ETF that invests in bank deposit accounts. The BetaShares Australian High Interest Cash ETF (ASX: AAA) pays interest that is generally better than at-call cash accounts, and competitive with term deposits – without the need to lock your funds away, or seek out ‘honeymoon’ rates. As of 30 June 2019, AAA is returning (after fees) 1.51% p.a.*
Investing in a bond ETF gives you the chance to earn regular income from either government bonds or corporate bonds, or from a managed portfolio that includes both.
Like cash, Australian Federal Government bonds are generally regarded as highly secure, and currently have a AAA credit rating. Because they are regarded as the safest of all bonds, they typically offer the lowest yields.
The latest addition to our fixed income suite is the BetaShares Australian Government Bond ETF (ASX: AGVT). The fund’s focus on ‘longer duration’ bonds means income potential is typically higher than other Government bond funds that do not have this focus. As of 23 July 2019, the yield to maturity on AGVT was 1.45% p.a.*
Yield to maturity (YTM)
YTM is the total expected return from a bond portfolio, including both income and capital return at maturity. It is based on current bond prices and no change in prevailing interest rates.
Corporate bonds typically offer a higher return, but come with greater risk. The risk varies depending on a number of factors, including the credit risk of the issuer. Higher-yielding bonds come with higher risk, while senior bonds issued by AAA-rated corporations provide a lower return because they are seen as safer.
Our Australian Investment Grade Corporate Bond ETF (ASX: CRED) offers exposure to high-quality corporate bonds, that have been included in the index based on their expected returns relative to government bonds of a similar maturity (noting there are also other index selection criteria).
In the 12 months since inception on 31 May 2018, CRED returned 11.36% (see chart below), making it the best-performing fixed income fund in Australia among the 218 funds in Morningstar’s database. For context, the median fund return was 5.94%. The fund benefited from an appreciation in the capital value of the portfolio as bond yields fell (bond prices rise as interest rates fall, all else being equal). As of 23 July 2019, CRED’s YTM was 2.65% p.a.*
Chart 1: CRED ETF performance in 12 months following inception versus S&P/ASX 200 Index and Bloomberg Ausbond Composite 0+ Year Index
Source: Bloomberg, BetaShares. Past performance is not an indicator of future performance. You cannot invest directly in an index. CRED ETF’s Total Return is after fund management costs, assumes reinvestment of any distributions and does not take into account tax paid as an investor in the ETF.
While CRED holds bonds paying a fixed rate of interest, our Australian Bank Senior Floating Rate Bond ETF (ASX: QPON), holds a portfolio of bonds issued by Australian banks that pay a rate of interest that changes as market interest rates change. If rates were to rise, the income these bonds pay would also increase. As of 22 July 2019, QPON’s running yield was 2.38% p.a.*
Our fourth and final bond fund is the BetaShares Legg Mason Australian Bond Fund (managed fund) (ASX: BNDS), an actively managed fund which holds a diversified portfolio of investment grade bonds including both government and corporate securities. This fund is managed by experienced investment managers who aim to add value through interest rate management, and sector and security selection. As of 22 July 2019, BNDS’ YTM was 1.71% p.a.*
Hybrids combine features of debt and equity. Because of the equity element, hybrids are regarded as higher risk than investment grade bonds, so generally offer higher returns. The features and risks of hybrids can vary significantly, so exposure via a diversified portfolio managed by an experienced hybrids specialist can reduce the risks of directly holding individual hybrids.
BetaShares’ Active Australian Hybrids Fund (managed fund) (ASX: HBRD) offers attractive, tax-efficient income paid monthly at a rate expected to be higher than cash and senior bonds. The fund holds a portfolio of hybrid securities, actively managed to reduce volatility and risk. The gross yield (inclusive of franking credits) of the portfolio as of 22 July 2019 was 4.35% p.a.*
Which to choose?
Our cash and fixed income funds have been created to provide solutions for a broad range of investors. Your financial circumstances and investment goals will dictate whether an exposure to cash, government bonds, corporate bonds, hybrids or a combination of these is most appropriate.
We believe our funds provide a simple, accessible and cost-effective way to construct this important part of your investment portfolio. As well as providing regular income, exposure to fixed income offers diversification benefits, noting that Australian bonds historically have tended to rise when Australian equities have fallen.
*Past performance is not an indicator of future performance.