DIY investors looking to diversify their portfolios with a liquid asset that generates regular income from their investments have three main options – invest in cash, buy dividend-paying stocks, or invest in bonds.
A bond is a debt instrument that a company can sell to raise money without diluting ownership over the business, which generates income for investors from the interest payments over a set period, with the principal amount typically repaid at maturity.
Fixed income ETFs
A cost-effective and convenient way to gain exposure to different types of bonds is through fixed income exchange-traded funds (ETFs).
Fixed income ETFs are investment funds traded on stock exchanges that primarily invest in various fixed-income securities, such as government and corporate bonds.
Corporate bond ETFs
Corporate bond ETFs focus on investing in corporate debt securities issued by companies.
These ETFs range from investment-grade bonds issued by companies with a higher credit rating (a low risk of default) to high-yield bonds (also known as junk bonds) issued by companies with lower credit ratings and, as such, carry higher risks.
The corporate bond fixed income ETFs available on the Clarity, by Investec platform include:
- iShares iBoxx $ High Yield Corporate Bond ETF (HYG-NASQ)
- iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD-NASQ)
Government bond ETFs
These ETFs invest in bonds issued by government entities, which can include:
- Sovereign bonds: Issued by national governments. Popular examples include U.S. Treasury bonds, German Bunds, and South African government retail bonds.
- Sub-sovereign bonds: Issued by regional or local government entities, such as state, provincial or municipal bonds.
The government bond fixed income ETFs available on the Clarity, by Investec platform include:
- iShares 1-3 Year Treasury Bond ETF (SHY-NASQ)
- iShares 3-7 Year Treasury Bond ETF (IEI-NASQ)
- iShares 20+ Year Treasury Bond ETF (TLT-NASQ)
Understanding your options
Corporate and government bond ETFs differ in important ways. These differences include the issuer of the underlying bonds, the associated risks and potential returns, and their role in a portfolio.
Some of the more important differences to consider when investing in fixed income ETFs include:
- Risks: Corporate bond ETFs carry higher credit risk (also known as default risk), whereas government bond ETFs generally have a lower credit risk, especially those investing in bonds issued by stable, developed nations.
- Returns (yield): Corporate bond ETFs compensate investors for the higher risk with higher potential yields compared to government bond ETFs with similar maturities.
Role in a portfolio
Investors often include government bond fixed income ETFs in portfolios as a safe-haven asset, as they can provide stability during times of economic uncertainty or market volatility due to their lower risk profile and potential negative correlation with equities.
In markets characterised by relatively low interest rates and disappointing returns from local equities and local multi-asset class funds, investors often show a preference for fixed income ETFs as they can offer higher risk-adjusted returns.
Additional fixed income ETF benefits:
- Cost and efficiency: Fixed income ETFs give investors a way to trade a portfolio of bonds – hundreds or even thousands – all in one transaction, directly through an exchange at a transparent price.
- Market access: Fixed income ETFs have made bonds more transparent and accessible to all types of investors.
- Liquidity: Bonds come with varying degrees of liquidity based on their terms. Individual bonds may not operate on a daily basis and are only over-the-counter transactions, whereas investing through an ETF structure provides greater liquidity for investors as they can buy and sell ETF shares on an exchange.
- Periodic income: The ability to generate regular income is another popular reason for including these ETFs in portfolios.
- Capital preservation: Fixed income ETFs can help protect investment returns against inflation.
Risk factors of fixed Income ETFs
In general, returns from fixed income ETFs are primarily driven by changes in interest rates and inflation expectations.
Fixed income ETFs are sensitive to changes in interest rates, holding an inverse relationship. That means when interest rates rise, the value of existing bonds tends to fall, and vice versa.
Central bank policy changes also influence bond yields. For instance, if the market expects the Federal Reserve in the US or the South African Reserve Bank (SARB) to raise interest rates, bond prices may fall in advance.
The sensitivity to changes in the interest rate is primarily determined by the duration of the bonds held in the ETF. Shorter-term bonds are typically held for 1-3 years. Intermediate-term bonds are held for 3-7 years, while long-term bond options include 10 or 20 years.
ETFs holding longer-term bonds will generally have a higher duration and are, therefore, more sensitive to interest rate changes, regardless of whether they are corporate or government bonds.
Economic growth is another influencing factor on yields from corporate bonds, as a growing economy generally improves the financial health of corporations, reducing their credit risk. This can lead to lower yields (and potentially higher prices) for corporate bonds as investors perceive them as less risky.
Anyone who chooses to invest in fixed income ETFs should closely monitor these macroeconomic factors to understand the potential risks and opportunities in their investments.
