Income Report / Income Report; Bond & Cash ETF's

By Market Matters 21 March 18

Income Report; Bond & Cash ETF's

Market Matters Income Report 21st March 2018

**We had a technical issue with the earlier version of the Income Report - apologies for the confusion**

The market opened higher this morning however is peeling away from earlier highs at time of writing. Seems no one is keen to step up to the plate ahead of the US Federal Reserve decision tonight on US interest rates. On the Shaw desk today, institutions are certainly not keen to take on risk in any meaningful size which makes for a fairly lacklustre day.

The market is trading flat around midday even though the heavyweight Energy, Materials and Financial sectors are in the green.

In terms of the MM Income Portfolio over the week, the portfolio was down by -0.77% in a market that was down only -0.22% Since inception (5/7/17) the portfolio has gained 6.12% tracking nicely above the market and above the portfolios benchmark. As always, to view all recent activity on both MM Portfolios - click here - or navigate to the recent activity screen on the website.

Using ETFs for Income – Part 2 - Bonds and Cash

We covered the topic of using ETF’s for Income two weeks ago with a specific focus on equity ETFs, those that trade in shares by either tracking an index or those that have a more specific, concentrated focus that are really more like managed funds or listed investment companies. The report can be viewed here. We’ll look at international ETFs in coming reports, however today we’re going to be more ‘boring’ focussing on income ETFs that have exposure to defensive bonds and cash, picking the eyes out of the most attractive ones – relatively speaking.

Before we cover specific funds, below is a quick reference guide from Morningstar about asset allocation and from a theoretical standpoint it sets out a possible asset mix for different risk profiles / return expectations. At MM we’re firmly of the opinion that each individual is different, has different goals, expectations and desires, and we see our roll as simply highlighting investment opportunities, whether they be ones we’re taking across our own portfolio ‘s or not, while providing a strong view on prevailing macro conditions – the interpretation of that work is left with the individual. Our focus is on financial markets, not understanding what the right asset mix is for a particular person however here’s a guide that may provide some structure to this conversation.


Source; Morningstar

If investors followed the approach above for a Balanced Portfolio then the model suggests 30% in fixed interest and 20% in cash, or in other words, 50% in defensive income assets. Naturally we spend a huge amount of time analysing growth assets, but less so on the defensive income piece – probably because it’s less exciting and returns are reflective of the reduced risk (and lack of excitement) . That said, ETFs are a way this can be simplified allowing for fairly easy comparisons to be made.

Right now cash and bonds are expensive on a relative basis, given low interest rates and coordinated central bank buying in the fixed income market over recent years. Cash in a term deposit can be compared to a fixed rate bond, while cash at call is more like a floating rate bond. We have Hybrids in the MM Income Portfolio but these aren’t bonds or cash – they sit somewhere in the middle of debt and equity and are not true fixed income (even though they are more attractive in our view right now).

The primary reason for holding true fixed income securities is to provide 1. Diversification benefits – they typically perform best in more challenging times for growth assets & 2. They provide more stable, regular income than equities. At the very broadest level, fixed income includes both govt and corporate debt with fixed rates or floating rate securities – they have varying maturities and the most common benchmark that is used for the Australian fixed income market is the Bloomberg Composite Bond Index.

Below is a list of income focussed ETFs as a starting point, but more work is certainly required.

Source; Market Index

QPON; this is a reasonably new addition to the Betashares stable – an ETF that provides exposure to Australian Bank Senior Floating Rate Bonds. These are not hybrids, they sit higher in the capital structure, have fewer conditions and consequently, pay a lower return. In an environment of rising rates we think it’s important to skew towards floating rate paper with shorter duration. Shorter duration reduces yield, however it also reduces the inherent risks – simply because there are less variables over a shorter time period. The QPON listed in June 2017 has less performance data however it has been reasonable to date.

In terms of the funds maturity profile, its skewed towards notes with a maturity of 3-5 years.

Importantly the bulk of holdings are well rated.

This fund now has $247m invested and growing and in our view is a reasonable candidate for fixed income investment

IAF; This is the iShares Core Composite Bond ETF that invests primarily in investment grade fixed income securities issued by the Australian Govt, State Govts and some corporates. This has been around since 2013 and now has $525m invested in it – returns are as you would expect from a bond product during a period where bonds have performed reasonably well. To give some idea of price, the fund trades at $106.41 highlighting the strength in bond markets in recent times.

Here is the mix of exposures in this ETF.

PLUS; This is another fairly recent listing from Vaneck Vectors and it now has $176m invested primarily in the corporate bond space contrasting to the Govt Bond skew from the IAF above. Returns are okay however they trail their benchmark in the short term.

It’s also important to recognise that this one has international exposures with Sth Korea representing ~7% of the funds exposure!

AAA; This is a cash ETF from Betashares, has $1.24b invested and is designed to outperform the 30 day bill swap rate. In simple terms it invests across bank deposits in Australia only – something very simple but a good relative insight into what cash will provide from an investment standpoint.

There are a range of fixed income and cash products to choose from however all are not the same and it’s important to understand the underlying exposures that a specific fund has. In a relative sense, we think Hybrids offer better risk adjusted returns (even now) and are clearly floating rate, however they are not true fixed income securities and will not provide the true defensive qualities of bonds or cash. 

Conclusion (s)

Bond and cash funds will provide real diversification, bonds are less attractive to us at the moment, while cash provides greater flexibility

We are more positive on floating rate products and those with shorter durations in the fixed income market.

If subscribers are looking for general information on ETFs, or specific funds, simply outline the fund and we can answer it in our Monday questions.

Have a great day

James & the Market Matters Team


Disclosure

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