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The Australian Composite Bond ETF (ASX Code: OZBD) continues the BetaShares ‘smart beta’ approach to investing within the fixed-income space. The Index which the OZBD ETF aims to track seeks to offer a higher yield than the widely-followed Bloomberg AusBond Composite Bond Index (AusBond), while broadly maintaining similar risk characteristics.
A smarter approach to passive bond investing
Although fixed-rate bonds form an important part of most well-diversified investment portfolios, innovations in bond market investing to date have tended to lag those in the equity market.
For example, Australia’s most widely followed Australian fixed-income investment index, the AusBond, follows a relatively simple strategy – its weights all investment grade fixed-rate bonds issued within Australia by their total issuance outstanding. The more bonds a company or government issues into the market, the higher the weight of these bonds in the AusBond – irrespective of yield and whether this extra issuance increases their credit risk.
The Index which OZBD aims to track takes a smarter approach to passive bond investing. Rather than simply weight all bonds by their issuance size, this new index, the Bloomberg Australian Enhanced Yield Composite Bond Index (EYI) uses a rules-based optimisation approach to maximise overall index yield subject to broadly preserving similar risk characteristics of the AusBond such as duration, credit and sovereign risk. Effectively, the optimisation process weights bonds based on their risk-adjusted income potential, subject to overall risk constraints.
This new index has been created by the very group (Bloomberg) that maintains the AusBond Index.
Attractive income potential
OZBD’s Index optimisation process historically has beaten returns from the AusBond Index over the long term. From inception in September 2011 to end-January 2021, OZBD’s Index produced annualised returns of 4.8% p.a. compared with 4.1% p.a. from the AusBond Composite, or 0.7% p.a. of outperformance.
In large part this higher return reflects the higher overall income return of around 0.5% p.a.*, due to modestly higher average exposure to duration and credit over this period.
Note although OZBD’s Index optimisation process means it has tended to maintain a modestly greater duration than the AusBond Index, the decline in yields over this period only contributed around 0.2% p.a. to the former’s outperformance**. What’s more, over the course of a whole financial year OZBD’s Index has tended to deliver stronger returns than the AusBond, irrespective of whether government bond yields rose (shaded areas) or fell. OZBD’s Index has outperformed the AusBond in the last ten financial years.
Financial year bond index performance
Attractive diversification potential
As evident in the chart below, OZBD’s Index has also provided good portfolio diversification benefits comparable to those of the Ausbond. During the seven worst monthly performances for the S&P/ASX 200 Index over the past decade, OZBD’s Index return has tended to broadly match that of the AusBond Index, producing a modestly better return four times and a modestly lower return three times.
Historical performance during equity sell-offs
The relatively attractive returns of OZBD’s Index in varied market environments reflect its focus on bonds with high income potential – which often fully or at least partially compensates investors for capital return weakness in periods of either rising government bonds yields or increasing credit risk. It also helps that the OZBD Index’s two sources of extra return premia – duration and credit – have tended to be negatively correlated over time, which has helped dampen overall return volatility.
Given the importance of bonds within most well-diversified investment portfolios, and especially given these times of challenging income returns, BetaShares is pleased to offer an intelligent approach to gaining cost-effective passive exposure to this asset class, an innovation we consider long overdue.
*Reflecting 0.3% p.a. high average yield and 0.2% p.a. from higher “roll return” due to investing in relatively steeper parts of the yield curve.
**EYI has maintained an average duration of 0.7 years greater than the AusBond. Given 10-year government bond yields have declined by around 2.6 percentage points over this period (or 0.26 percentage points per year), this has contributed only 0.2% p.a. (0.7*.26) to compound annual outperformance. The impact on return from narrowing credit spreads over this period has been fairly negligible.