No Time to Risk: How To Pick a Bond ETF For the Long Run

The Definitive Guide to Bond Index Investing - PART 4

Welcome to Part 4 of our Definitive Guide to Bond Index Investing.

Bonds are a shield for your medium and long-term portfolios, including when deflation strikes. Ready to select a long term Bond ETF? Let’s break it down in 5 steps.

KEY TAKEAWAYS

  • Your Investment Horizon: The longer your horizon, the higher the duration. Most ETFs have a duration between 6 and 8 years.
  • Geographical Diversification: You may choose Issuers in the EU or the UK, or diversify globally. Some ETFs, like the Vanguard Global Aggregate Bond UCITS ETF, exclude China, while the iShares and SPDR Global Agg ETFs include it.
  • Risk Vs Yield Trade Off: Today, Aggregate Bond ETFs provide between 0.5% to 1.5% of incremental yield, compared to Government Bonds. But, a higher proportion of US Treasuries within a Bond ETF helps during a crisis, like COVID-19.
  • ETF Characteristics: Fees matter less, as UCITS funds are quite competitive. ETF jurisdiction has also low impact, but Broker Availability, Size, Dividend Distribution, and currency hedging are key.
Here is the full analysis

STEP 1 - INVESTMENT HORIZON

By far, Your most important decision.

First, you need to account for your investment horizon. The higher the duration, the better it is suited for long term investing:

  • For Bonds  the duration, in years, should broadly match the investment horizon.
  • For Bond ETFs – the horizon may be somewhere between duration and two times duration. In the previous article we explained why.

Duration is the risk you take but also the protection you may get in case of an economic downturn, particularly deflationary. It comes with a rebalancing benefit. For example, if your Investment Horizon is 15 years, selecting a Bond with a similar term/duration is reasonable. However, if you select a Bond ETFa duration of 8+ years could be a good starting point. In practice, the choice for a long term investor is somewhat limited.

Today, most ETFs have durations around 6 to 8 years, which is adequate for a medium to long term investment horizon.

STEP 2 - COUNTRY DIVERSIFICATION

More Diversification, Similar Yield

With respect to issuing countries, Bond ETFs may be of two types:

  • Local Bonds, e.g. UK Bonds or European Bonds
  • Global Bonds (also called International) – Diversified Developed Markets, or concentrated in G7 Countries.

Which countries will you be exposed to in a European ETF?

Single Country or Area Bond ETFs are focused on either high-quality EUR bonds or the UK.Let’s have a look at a typical allocation of such fund. European Bond ETFs have a high allocation to countries issuing larger amounts of public debt such as Italy, France or Germany.

EUROPEAN Government BOND ETF

Source: State Street (SPDR BBG Barclays Euro Government Bond UCITS ETF). As of Q2 2020.

Which Index Do Global Government Bond ETFs Track?

Global Bond ETFs with a focus on Developed Countries track either of two Benchmarks:

  • FTSE World Government Bond Index – Developed Markets (illustrated below)
  • FTSE Global Group of Seven (G7) Index
Let’s have a look at a typical allocation is such a Bond ETF.

GLOBAL Government Bond ETF

Source: DWS (Xtrackers II Global Government Bond UCITS ETF). As of Q2 2020.

Government Bond ETFs vs G7 Countries

  • The exposure of a World Government Bond ETF (Developed Markets) is to countries such as the US (35-40%), Japan (approx. 20%) but also various European Union members, the UK, Canada and Australia.
  • Bond ETFs with G7 Countries are even more concentrated, particularly as it relates to US Treasuries. These Bond ETFs also include Canada, a couple of key EU states like France, Germany and Italy, Japan, the United Kingdom.

is there a Risk benefit To Global Bond ETFs?

Yes, compared to local Bonds like UK or a single State, Global Bond ETFs provide better diversification without, reducing returns. 

Is There a Return Benefit to Global Bond ETFs?

Since you will likely be hedging currencies, the long term return from Global Government Bonds and your local Government Bonds tend to be similar, as far as financial theory goes.

STEP 3 - RISK vs YIELD TRADE-OFF

MORE CORPORATES, MORE YIELD.

When choosing the debt Issuer type, you have the choice between ETFs composed of:

  • Government Bonds – Only State Guaranteed Bonds.
  • Aggregate Bonds – Include 60% to 70% of Government Bonds. The rest are high-quality corporate or, for global funds, mortgage bonds.

What is an Aggregate Bond ETF?

Aggregate Bond Funds are the broadest Fixed Income ETFs.  About two-thirds are government bonds and c. one-third are corporate or highest quality US mortgage bonds (often implicitly guaranteed by the U.S. Government).

What is the Breakdown of Aggregate Bond ETFs?

Global Aggregate Bond ETF will have exposure to the highest quality American Mortgage Securities while the European Aggregate Bond ETFs won’t.

Issuer Exposure

ExposureGlobal BondsEU Bonds
Government63%68%
Financial13%18%
Mortgage Securities10%0%
Consumer & Industrial3%6%
Utilities2%2%
Other8%6%
Source: Bankeronwheels.com, iShares.

Are Aggregate Bond ETFs lower quality?

Yes, marginally. Government Bond ETFs give you the best protection and will react faster in a downturn. You can see the comparison in the case of Covid-19 Sell-off in the step 5 below.

SUMMARY - What are the big 4 Bond ETF Types?

In Step 2, we have covered possible geographical areas (i) International Bonds and (ii) Local Bonds. Now, if we add two more dimensions (i) Government Bonds or (ii) Aggregate Bonds we end up with four possible Bond ETF Types:

  • Global + Government  (#1 below)
  • Local + Government (#2 below)
  • Global + Aggregate (#3 below)
  • Local + Aggregate (#4 below)

Four Bond ETF Categories

STEP 4 - ETF Characteristics

Make a call on Currency RIsk.

Should you hedge currency risk?

Hedging Bonds will reduce the volatility of your portfolio. In this article, we only selected Bond ETFs that are hedged. But is it always needed? We cover this topic extensively in the next article.

Accumulating or Distributing Share Class?

The bonds that pay interest can be distributed through dividends. Choosing between accumulating or distributing funds is among the first choices investors in Europe make. The appropriate option may influence your taxes.

In most Continental Europe, accumulating funds generally have lower taxes because they fully reinvest dividends without triggering dividend taxes. In the UK’s deemed tax on dividends, taxes all accumulating fund dividends at the same tax rate as normal dividend. Other countries where distributing and accumulating is not clear-cut include Switzerland or Germany. If you’re unsure which to choose, check our dedicated guide.

STEP 5 - ETF Performance

COVID-19 Sell-off

How did funds perform?

Bond ETF Performance in March 2020

Source: Bloomberg

The Index Funds that I reviewed had generally performed well in the COVID-19 Sell off:

  • Global Government Bonds (G-7) – were the most resilient, with a drawdown of only 3%. It’s perhaps no surprise since US Treasuries are the safest assets and these represented 44% of the Index.
  • Global Aggregate Bonds – benefited from exposure to the US and a flight to quality. iShares Global Aggregate ETF marginally outperformed Xtrackers Global Governments, but this could be due to the liquidity of EUR classes, since USD classes had a very similar drawdown at -5%.
  • European Government Bonds – had a drawdown between -8 and -9% for a similar duration
  • European Aggregate Bonds – had the worst drawdown (-11%). But, they provide incremental yield vs European Government Bond ETFs.
  • Gold – fell by 12.6% before quickly rebounding, while the EuroStoxx 50 tumbled 39%.

Is Tacking Difference Important?

By the time you have applied the filters from steps 1 to 4, you should already have a solid candidate. Unlike Equity ETFs, for quite a few European hedged Bond ETFs, Tracking Difference may be misleading. TER could be a good proxy to assess how cheap funds are. You may (or not) look at costs – all these funds are very competitive from an ongoing charges perspective. 

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BOND ETF Comparison Table

How to narrow down your options

The below table is broken down by the categories introduced above:

  • Size – Most funds have at least 1 bn Euro of assets under management. This includes all shares classes.
  • Duration – For most funds is between 6 and 8 years, making them good candidates for medium-term (MT) to long-term (LT) investment horizons.
  • Yield-To-Maturity – The yield below is the unhedged Yield. A currency hedge return needs to be added to estimate the expected total return. How is it calculated? Read the next article.
  • Benchmark – In most categories, ETFs track the same benchmarks. The exception is Vanguard Global Aggregate Bond UCITS ETF that tracks the Bloomberg Global Aggregate Float Adjusted and Scaled Index. The Float Adjustment and Scaling does exclude China. Vanguard’s ETF Yield-to-Maturity is around 1% higher than the iShares Core Global Aggregate Bond UCITS ETF and the SPDR Bloomberg Global Aggregate Bond UCITS ETF, due to the exclusion of China and lower weights of e.g. Japan.
  • Accumulating and Distributing Share Class Availability – This includes unhedged European and UK ETFs, and hedged Global ETFs.

Best Bond ETFs - Comparison

Fixed_Income_ETF-Full_NameSizeDur.YieldTERMTLTAccum.Distr.BenchmarkCategory
Xtrackers II Global Government UCITS ETF2.07.603.50%0.25%
USD,CHF,GBPEUR,GBPFTSE World Government Bond - Developed MarketsGlobal & Government
iShares Global Government Bond UCITS ETF2.27.403.60%0.20%
USDEUR,GBPFTSE G7 Government Bond IndexGlobal & Government
iShares Core Global Aggregate Bond UCITS ETF6.76.603.95%0.10%
USD,EUR,SEKUSD,GBPBloomberg Global Aggregate Bond IndexGlobal & Aggregate
SPDR Bloomberg Global Aggregate Bond UCITS ETF2.76.653.95%0.10%
USD,EUR,CHFUSD,GBP,EURBloomberg Global Aggregate Bond IndexGlobal & Aggregate
Vanguard Global Aggregate Bond UCITS ETF3.36.905.00%0.10%
USD,GBP,EUR,CHFEUR,GBPBloomberg Global Aggregate Float Adjusted and Scaled IndexGlobal & Aggregate
Xtrackers II Eurozone Government Bond UCITS ETF2.67.403.20%0.15%
USD,EUREUR,GBPIBOXX® € Sovereigns Eurozone IndexEuropean & Government
iShares Core Euro Government Bond UCITS ETF4.27.303.30%0.09%
CHFEURBloomberg Barclays Euro Treasury Bond IndexEuropean & Government
Vanguard Eurozone Government Bond UCITS ETF1.87.403.20%0.07%
EUREURBloomberg Euro Aggregate Treasury IndexEuropean & Government
Lyxor Euro Government Bond UCITS ETF1.27.303.30%0.14%
EUREURBloomberg Barclays Euro TreasuryEuropean & Government
iShares Euro Aggregate Bond ESG UCITS ETF1.66.503.50%0.16%
EUREURBloomberg MSCI Euro Aggregate Sustainable and Green Bond SRI IndexEuropean & Aggregate
SPDR Bloomberg Euro Aggregate Bond UCITS ETF0.66.403.50%0.17%
-EURBloomberg Euro Aggregate Bond IndexEuropean & Aggregate
iShares Core UK GILTS2.38.504.65%0.07%
-GBP,EURFTSE Actuaries UK Conventional Gilts All Stocks IndexUK & Government
Lyxor Core FTSE Actuaries UK Gilt18.604.60%0.05%
-GBPFTSE Actuaries UK Conventional Gilts All Stocks IndexUK & Government
Vanguard U.K. Gilt UCITS ETF0.310.004.70%0.07%
GBP, EURGBPBloomberg Sterling Gilt Float Adjusted IndexUK & Government
Source: Bloomberg, ETF providers' websites, Bankeronwheels.com. Data as of August 2023. MT = Medium Term Investment Horizon, LT = Long Term Investment Horizon. Size in billion EUR includes all share classes. Unhedged Yield to Maturity is being shown. This is not the approximate expected return on those ETFs, as hedging return needs to be added. See next article to understand how to calculate the return you can expect while accounting for hedging. Distributing and Accumulating Share Class availability shown as unhedged for Euro & UK ETFs and hedged for Global ETFs.
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Is there a best bond ETF?

Which Global Bond ETF should I choose?

After choosing the duration, Bond Types, pick the ETF in your currency to reduce FX Risk.  Then, choose between accumulating and distributing based on your personal situation. Finally, you may consider performance, marginal yield differences and costs.

For example, if you consider a Global Bond ETF, some good candidates may include:

  • For Best Protection: iShares Global Government Bond UCITS ETF
  • For Incremental Yield: When unhedged, the Vanguard Global Aggregate Bond UCITS ETF provides the best yield, due to lower allocation to low yield countries like Japan. It also excludes China, that today risks deflation.
  • For Largest Diversification: iShares Core Global Aggregate Bond UCITS ETF, or SPDR Bloomberg Global Aggregate Bond UCITS ETF

These are marginal preferences. The wider conclusion is that, given that I have pre-selected only the most established names for this analysis, any of the above funds are good diversifiers for your portfolio.

But, some of these characteristics, like yield, change when currency hedging is in place. Read my next article to understand how.

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Next Steps

In the next article, we will look at whether hedging currencies is a good idea, and why you need to account for Hedge Return when calculating expected returns for Bond ETFs.

Thank you for reading.
Good Luck and Keep’em* Rolling!

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