I came across this great portfolio allocation article in ‘The Telegraph’, a British paper, last week. Two fund managers discuss the strategy for their £1.7 billion bond fund, supporting our current portfolio suggestions. There’s a big twist in the second part of this note, with a couple of client stories that really shed light on some of the difficulties in index investing
“Bond investors need to lower their expectations”
That’s the general message from two London bond fund managers in an article from the London Telegraph. They recount their portfolio construction strategy and investment philosophy in a low interest rate environment. It’s pretty similar to our thinking, and gives me confidence we are on the right track – and anyway it’s just interesting to read about how professional bond managers think. The note can be accessed here.
Investors need to look deeper at alternatives, particularly ETFs
Recently I was talking to a client about his choices between investing in bond funds and directly through FIIG, and he told me that his advisor had recommended he invest in the Vanguard Australian Fixed Interest Index ETF. Vanguard is one of the biggest managed fund/ ETF players and well regarded, so I thought I’d investigate.
There are two key points worth sharing:
- Income (running yield) of the ETF is currently 4.09%. This is how the advisor had sold it to him – low risk, high income. And he’s not wrong – that’s basically the dividend yield of the ASX200, but in bonds not equities…
- The yield to maturity of the fund (remembering that funds don’t have a maturity, but this is the yields of all the bonds in the index which given it is passive, will be held to maturity) is 1.94%. I’ll say that again – 1.94%. This bit was completely omitted by the advisor.
The client wasn’t aware of this and told me he would never invest into the fund for a 1.94% return – why would anyone, when government guaranteed term deposits are paying around 2.5%? While ETFs may appear attractive, you need to look deeper as they are not “set and forget” securities as many may think.
This is why we encourage direct investment, and focus on what matters when investing in bonds.
Over time, the bond ETF income return will trend towards the yield to maturity. The bonds with high coupons will mature. Current high income infers the bonds must be trading at a premium to par now, so will lose capital value as the bond price heads back to par. This should in turn reduce the unit price value over time. When individual bonds mature, funds will be reinvested at the new lower coupon rate and the returns will be a lot lower.
Another issue to consider which is very important, particularly since approximately 89% of that index is treasury and government related, is that the duration* of Commonwealth government bonds is increasing. See the chart below.
The Government is about to issue a 30 year bond for the first time. Two years ago, the duration of the index was about 3.5 years – so on average, a relatively low interest rate exposure. Now it is 5 years – a 50% increase in duration, while yield to maturity has fallen under 2%.
I do actually agree with most commentators (who generally talk about bond bubbles without really understanding what they are) that government bonds are not good value at these levels, yet this ETF has invested in 89% treasury or government related bonds and is being recommended to clients!
So in summary, portfolio construction is really important, it requires some deep thinking (which we do), and ETFs can help but are unlikely to deliver the expected outcome.
Another interesting sidenote
On reading my note above, I received this from one of my clients.
Hi Jon,
This is VERY interesting stuff, and I am just such a client who has put $350,000 into VGB in recent months.
I'm down $5,000 on capital quite apart from the interest component.
I'll take my losses today, and reinvest with FIIG next week.
MIPS account?.. or other suggestions?
Regards, Roger
Summary
Roger is now weighing up investing in DirectBonds or via the Managed Income Portfolio Service (MIPS). A DirectBond portfolio will take a bit more work, particularly if Roger wants to trade and try and maximise overall returns. However, I’ll help, as will other dealers to make trade suggestions.
MIPS has the benefit of scale, institutional pricing and a dedicated portfolio manager who will trade as they see opportunities in the market. Investors can receive income as it is paid, or opt to reinvest if they don’t need the cashflow. Probably the greatest benefit is the immediacy of the trade. The portfolio manager makes decisions based on predetermined mandates and what looks attractive in the market. If you have a busy life and like travelling, this could be the better option.
*Duration – Is a useful measure of risk in bond investment represented in years. Developed in 1938 by Fredric Macaulay, duration measures the number of years needed to recover the cost of the bond, taking into account the present value of all coupon payments and the principal payment received in the future. Bonds with higher duration typically carry more risk and thus have higher price volatility. For vanilla fixed rate bonds, duration is always less than time to maturity, for floating rate notes, duration is typically very short and based on the next coupon reset date.
Modified duration – Modified duration is a measure of the price sensitivity of a bond to interest rate movements. Typically, modified duration provides an estimate of how a bond will change in price for a 100 basis point (bps) or a 1% movement in interest rates. For example, say interest rates change by 1% then a $100,000 par value bond with a six year modified duration could expect a corresponding 6% change in its price, that is 1% x 6 years = 6% change.
If the traded yield on that security moved up by 1% the next trading day, then the market value of that bond would fall roughly 6% from $100,000 to $94,000. Alternatively, if the traded yield on that security declined by 1% the next trading day, then the market value of the bond would rise by 6% to $106,000.