Investing in bond and gilts has become easier with the advent of ETFs.
Big claims are made for fixed-income securities such as they're less risky and less volatile than equities, investors should increase the proportion of fixed income in their portfolio as they grow older and so on. Many investors have heard the advice but found it more difficult to put into effect.
Although ETFs look as if they offer a straightforward way to invest, fixed income does present some hidden traps and as with other assets, it matters when you invest.
Fixed-income ETFs, for better or worse, open up a form of bond trading to smaller investors for the first time, and this may come to be seen as an investing revolution -- or another way to lose money.
The risk factors
Of the two basic risk factors, credit risk and inflation, the former seems a lot less of a threat than it did 6-12 months ago.
Investors' fears that corporate bond issuers wouldn't survive to repay them rocketed at the end of last year and then recovered strongly from March onwards. Anyone who bought iShares £ Corporate Bond ETF (LSE: SLXX) will have done very nicely out of it so far.
The reason for the recovery is that everyone's expectation of corporate defaults has dropped away to normal levels (worldwide bond issuer defaults average about 4% over the years). However, although this ETF is currently only trading at a slight premium to the par value of its constituents (and still pays a 6.2% dividend for the trailing 12 months) the period of strong recovery may be over. Like equities, it may suffer with the end of quantitative easing.
Where investors really benefit when it comes to corporate bond ETFs is in spreading their risk; it's not possible to buy the bonds of individual corporates in small enough quantities for ordinary investors to create a diverse portfolio. As well as protecting against the risk of default, a corporate bond ETF saves the investor the trouble of having to re-invest the proceeds if a company redeems their bond ahead of time.
Inflation
If historically high concerns about credit risk are now in the past, the inflation dilemma is still with us. Certainly, in the UK the balance of opinion seems to support the likelihood of a surge in inflation in the next five years.
The improvement in the price of UK index-linked gilts and ETFs such as iShares £ Index-Linked Gilts ETF (LSE: INXG) also supports this view (with their low risk of default making them extra attractive currently).
There's no getting away from inflation considerations for fixed-income investors. Even those who plan to hold bonds for the long term need to take inflation into account in timing when to buy and sell. Moreover, there are some quirky elements to the art of inflation forecasting.
So while you hold bonds actual inflation is your main concern, but if you're timing the buying or selling of them the market's inflation expectations become much more important. Not only that, but the investor needs to hazard a view on whether the expectations are right or not.
Even index-linked gilt ETFs can be snare when inflation expectations have pushed the price and then go into reverse or turn out to have been overdone.
Information deficit
Unfortunately, ETF sponsors don't seem to be making it very easy for investors to assess their fixed-income ETFs.
Take, for example, iShares FTSE UK Gilts 0–5 years ETF (LSE: IGLS), tracking UK gilts whose maturity is up to five years away. This is currently trading at premium to the par values of its index constituents. That's to be expected right now because of the previously mentioned safety attractions of government stock.
You can tell that there is a premium because the yield to maturity (1.6%) is a lot less than the flat yield (4.4%) but why not put the par value (as it were) of the ETF on the website? The par value of the FTSE gilt index constituents should be 100 (I believe) but iShares provide neither the par value of the ETF nor its replication basis to help you work it out for yourself.
Other pieces of information that could usefully be made more accessible are the weighted average coupon of the ETF's constituents and the average maturity of the constituents. It would also be good to have charts that showed the change in yield and yield to maturity day by day alongside the price changes.
Other factors to consider
Don't forget that, whereas bond prices are 'dirty' (i.e. with the outstanding coupon incorporated into the price), the fixed-income ETF's income will be paid like a share dividend quarterly or twice-yearly. It would be shame to miss six months' income by a day or two and there can be a fall in share price as the ex-dividend date passes.
Standard advice is also to hold a balance of bonds with different maturities. iShares offers ranges of $ and € government bond ETFs with the complete scale of maturities. For UK gilts there is only 0–5 years and iShares FTSE UK All Stocks Gilt (LSE: IGLT). db X-trackers sponsors an iBoxx Gilts Total Return Index ETF (LSE: XBUT), which makes sense if you want to avoid having to worry about ex-dividend dates.
I am still wary of fixed-income ETFs and inclined to wait for prices to fall. To avoid mistakes over timing, building up a fixed-income ETF portfolio very gradually would seem to be a wise option.
One way around the inflation forecasting conundrum might be to go for a euro government bond ETF such as iShares Barclays Euro Treasury Bond ETF (LSE: IEGA) on the grounds that the currency risk may be easier to live with than the UK inflation risk, but at present all the ETFs tracking euro government bonds seem to be very thinly traded.
More from Francis Groves:
