How To Choose A Bond ETF for Long Term Investing
When you’re investing for the medium to long term, bonds can provide portfolio protection, including in deflationary scenarios, that most investors don’t usually think about.
Today, let’s go through a 5-step ETF selection process.
KEY TAKEAWAYS
- Your Investment Time Horizon – The most important decision relates to the ETF’s duration. The longer your horizon, the higher the duration you may consider.
- Geographical Diversification – You may choose an ETF with Bonds from the country/area you live in (e.g. Europe / UK) or diversify your risk further globally.
- Risk and Return – You have the choice between Government Bond ETFs and Aggregate Bond ETFs that blend Government and Highly Rated Corporate Bonds. An Aggregate Bond ETF has marginally higher risk but provides with an incremental return.
- ETF Characteristics including Availability with your Broker, Fund Size, Dividend Distribution Policy or Share Class Currency.
- Performance and Fees – European and International Bond ETFs have generally performed well during the Coronavirus Market sell-offs. Fees are generally competitive, and not as crucial as for some other ETF categories.
Here is the full analysis
STEP 1 - INVESTMENT HORIZON
By far, the 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 or term should broadly match the investment horizon, in years.
- For Bond ETFs – the horizon may be somewhere between duration and two times duration. Here is why.
For examples, if your Investment Horizon is 15 years, selecting a Bond with a similar term/duration is reasonable. However, if you select a Bond ETF, a duration of 8+ years could be a good starting point. In practice, the choice for a long term investor is somewhat limited.
Most ETFs have durations around 8–10 years, which are adequate for a medium to long term investment horizon.
STEP 2 - COUNTRY DIVERSIFICATION
More Diversification, Similar Yield
Outside the US, Bond ETFs can have 3 types of exposures:
- Local Bonds, e.g. UK Bonds or European Bonds
- International Bonds – Developed Markets
- International Bond – Concentrated in G7 Countries
What is the country exposure in a Local Market Bond ETF?
Single Country or Area Bond ETFs are focused on either high-quality EUR bonds or the UK. European Bond ETFs have a high allocation to countries issuing larger amounts of public debt such as Italy, France or Germany.
Typical Allocation of European Government Bond ETF
What International Government Bond ETFs can I choose?
International 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
Typical Allocation of a Developed Markets Global Government ETF
What is the difference between Government Bond ETFs tracking Developed Markets and G7?
- The exposure of a World Government Bond ETF (Developed Markets) is to countries such as the US (35-40%), Japan (approx. 20%), European Union, UK, Canada and Australia.
- Bond ETFs with G7 Countries are more concentrated, particularly as it relates to US Treasuries. These bond ETFs include only Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.
What is the benefit of International Bond ETFs?
In a nutshell, International Bond ETFs provide better diversification without reducing returns.
Does the choice between International and Local Bond ETF affect performance?
Since you will likely be hedging currencies, in the long term return from International Government Bonds and your local Government Bonds tend to be similar as far as financial theory goes.
STEP 3 - RISK AND YIELD TRADE-OFF
More Diversification, Similar Yield
When choosing the debt Issuer type, you have the choice between ETFs composed of:
- 100% Government Bonds
- Aggregate Bonds (that only include c. 60% Government 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 products (e.g. implicitly guaranteed by the Government)
What are all bond ETF Types I can choose from?
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.
- International Government Bond ETFs (#1 below)
- International Aggregate Bond ETFs (#3 below)
- Local Government Bond ETFs (#2 below)
- Local Aggregate Bond ETFs (#4 below)
Bond ETF Categories
What is the typical Sector Breakdown In an Aggregate Bond ETF?
- The yellow breakdown is the sector allocation of the iShares Euro Aggregate ETF while the orange one is the iShares Global Aggregate ETF
- While the composition may be similar the geographical coverage means that the International Aggregate Bond ETF will have exposure to the highest quality American Mortgage Securities while the European one won’t
- Non-Government Bonds provide you with enhanced yield compared to Government
European Aggregate ETF
International Aggregate ETF
Does the choice between Government and Aggregate Bond ETF impact quality and performance?
- Government Bond ETFs give you the best protection and will react faster in a downturn
- For example, in August’20 the Yield to Maturity (8 yr duration) for most Developed Countries varied between 0.5% to negative but when averaged out and swapped to EUR Government Bond Index Yields were negative
- Aggregate Bond ETFs remain high quality but also provide a bit more income (Government Bond yields in EUR area can be negative so Aggregate Bonds provide for higher income)
- In August’20, the Bloomberg Barclays Global Aggregate Index Hedged to EUR yielded 0.9%
STEP 4 - NARROW DOWN BASED ON ETF CHARACTERISTICS
Should I hedge currency risk in a Bond ETF?
Hedging Bonds will reduce the volatility of your portfolio.
If you want to understand how it works, read this guide.
Should I choose an Accumulating or Distributing Bond ETF Share Class?
The Bonds that pay interest can be distributed via dividends.
Choosing between accumulating or distributing funds is among the first choices investors in Europe make. The appropriate option may reduce 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 dividends except when part of an ISA account (where you don’t pay taxes). Other similar countries where distributing and accumulating makes marginal/ no difference include Switzerland or Germany (again, except if in tax-protected wrappers)
- Verify ETF tax treatment for your country before choosing an accumulating or distributing ETF
If you’re just starting out, here is a guide on how to choose between Distributing vs. Accumulating ETF Share Classes.
Note that ETF Domicile has a lower impact than for Equities since US Bonds are not affected by withholding tax.
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STEP 5 - CONSIDER COST AND PERFORMANCE
How did funds perform during the March'20 sell-off?
EUR denominated International and European Bond ETFs performance during March 2020 Sell-Off
Reviewed Index Funds have generally performed well in the COVID-19 Sell off of March 2020:
- International Government Bonds from G-7 Countries have performed best with a drawdown of only 3%. It’s perhaps no surprise since US Treasuries are the safest assets and these represent 44% of the Index.
- International Aggregate ETFs have also benefited from exposure to the US and a flight to quality. iShares International Aggregate marginally outperformed Xtrackers International Governments but this could be due to the liquidity of EUR classes since USD classes had a very similar drawdown at -5%.
- European Government Bond ETFs had a drawdown between -8 and -9% for a similar duration
- European Aggregate Bond ETFs have had the worst drawdown (-11%) since they provide incremental yield vs. Government Bond ETFs
- Gold (in EUR) fell by 12.6% while EuroStoxx 50 tumbled 39%.
Should I choose a Bond ETF based on Tacking Difference?
Unlike Equity ETFs, for quite a few European hedged Bond ETFs, Tracking Difference may be misleading.
TER/OCF could be a good proxy to assess how cheap are funds.
You may (or not) look at costs – all these funds are very competitive from an on-going charges perspective.
By the time you have applied the filters from steps 1-4 you should already have a solid candidate.
Which Bond ETF should I choose?
After choosing the duration and types of bonds in the Fund, 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.
Based on the Coronavirus Bond ETF Performance and assuming a Medium Horizon, some candidates would include:
- For Best Protection: iShares Global Government Bond ETF (G7 Index)
- For Best Protection/Yield Trade-off: (i) iShares Core Global Aggregate Bond ETF, (ii) SPDR Bloomberg Barclays Global Aggregate Bond ETF or (iii) Vanguard Global Aggregate ETF
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CONCLUSIONS
The key players are somewhat different from the US Markets – while BlackRock’s iShares, State Street SPDR and Vanguard are all present, local players have also a strong footprint – Deutsche Bank’s Xtrackers and LYXOR/Amundi are solid candidates.
The choice is somewhat narrow compared to the US Market but the above funds are fairly large and liquid.
All ETFs performed quite well in the context of the crisis.
Pure Government Bond ETFs with US exposure provided marginally better protection.
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TECHNICAL ADDENDUM
The yield you get in your currency should be a secondary criterion, but it is a trade-off with the quality of the underlying Bonds (Government vs Aggregate).
Be careful, the Yield from the Factsheet is just part of the story.
Aggregate Bond ETF Yield can’t be locked in. It can be locked in for Government Bond ETFs. While locking a yield is relatively straightforward for Government Bond ETFs (you can play with my Bond ETF Calculator to understand why), for Aggregate Bond ETFs the return you get may differ.
This is because Corporate Bonds trade with an additional spread to Government Bonds and this may fluctuate over time.
For all types, the initial Yield to Maturity is still the best indication of future returns.
Don’t forget that in Europe, what counts is the return you will get after accounting for currency hedges.
Unfortunately, I have not seen anywhere any proxy for Bond ETF hedged yield. ETF providers only show the unhedged yield, and comparison websites ignore yield altogether.
To simplify your task, I have calculated in the table above the approximate yield you may aim to get from the ETF including (i) what Bonds generate aka the Factsheet Yield and (ii) the expected hedge return in the first 12 months (the hedges are then rolled).
The overall expected yield, after accounting for hedge return can be read in the EUR/GBP Hedged Yield columns.
The universe of possible Bond ETFs for European Investors includes (i) Global Bond ETFs and Local Bond ETFs (e.g. European or the UK).
In theory, whether you choose a Global fund that is currency hedged or a local fund in your currency, the yield will be similar (for a comparable duration).
This is fairly close based on my calculations. In the above table, for Global Bond ETFs the hedged yield broadly ties out with ‘pure’ European or UK Bonds, as the theory predicts.
For example:
- Xtrackers Global Government Bond UCITS ETF Yield EUR Hedged is fairly close to European Government Bond ETFs Yield (in EUR)
- iShares Global Government Bond UCITS ETF Yield GBP Hedged is broadly in line with iShares Core UK Gilts (in GBP). It is a bit lower, but this is due to lower duration.
That’s why I wouldn’t try to choose an ETF purely because it yields a few basis points more than its rival but rather take a look at all sets of selection criteria.
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