Investing in government bond ETFs

by , 5th January 2018

Government bonds form the backbone of many investment portfolios. They’re especially popular with pension funds who like their safety and predictability. Government bonds issued by the US and UK are seen as pretty much 100% safe – the UK government has never defaulted on any bonds it’s issued.

The big downside for bonds is that the yields are exceptionally low at the moment, so you might get caught out if interest rates rise more quickly than markets expect. Still, if that happens, you’ll still benefit from the predictability that most bonds offer.

It’s relatively easy to invest in UK Government bonds, known as Gilts, you can buy them with your stockbroker, or via the Government’s Debt Management Office (DMO). But if you want to build a wide portfolio of gilts, you may prefer to invest in a fund. The fund route can also give you exposure to bonds issued by other governments.

Active or passive

Just as with equities, there’s a passionate debate about whether you should go for a passive bond fund, often an ETF, or an active one, typically a unit trust or OEIC. As you’d expect, a big part of the debate is around performance. Pimco, an active bond manager, published research in 2017 suggesting that active bond funds tend to beat passive funds. Several other surveys suggest that passive funds are the better option with many active funds struggling to beat their benchmark.

Another concern is that passive bond funds are inevitably weighted towards the biggest borrowers whether that’s governments or companies. So that may mean you end up investing more money in the riskier bonds because the borrowers may be weighed down with too much debt. On the other hand, the largest borrowers may just be the largest countries or companies, and there’s no sign that this issue has damaged performance so far.

Of course, passive bond funds are normally cheaper than their active bretheren. That’s an especially important point given that returns from bonds are likely to be on the low side over the next decade – simply because current valuations are so high, and yields are so low.

What to look for

So what should investors focus on when they’re choosing fixed income ETFs?

Peter Sleep of Seven Investment Management (7IM) says ‘investors should focus on the same things they focus on when they make any investment. They should think about the amount of risk they want to take, how long they will be invested for and the sort of return they hope to achieve.’

Sleep says that his firm is generally ‘agnostic’ on the choice of vehicle but nonetheless 7IM tends to prefer active managers for higher risk bond funds such as emerging markets or high yield bond funds. For high quality government bond funds, including gilts, 7IM is more likely to go for a passive fund.

If you decide to buy an ETF, Sleep stresses that you should be sure it has UCITS in the title and that is has UK reporting status, if you’re a UK taxpayer. (UCITS is the EU’s regulatory system for investment funds.) It’s also important to look at the difference between the ‘buy’ price and the ‘sell’ price – the bid offer spread – and make sure it’s not too much.

Sleep also says investors should consider the desired currency mix. ‘Bonds are much less risky than equities, and we generally recommend that investors consider sterling hedged products to take away the risk of currency volatility.’

Maturity

Many ETFs focus on bonds with a particular maturity, say 1 to 3 years. If a bond is only two years away from redemption, the impact of a rise in interest rates will be lower than for a bond that has ten years left to run.

If you’re worried that interest rates are set to rise a lot, you could reduce your risk by investing in bond ETFs that focus on bonds with shorter maturities.

You may also see the term ‘duration’ used in this context. It’s not the same concept as ‘maturity’ as it takes into account other payments during the life of the bond, not just the repayment of the principal at maturity. Duration is often defined as the impact of a rise or fall in interest rates on the value of a bond. If a bond has a duration of 6 years, then its price will rise by around 6% if interest rates fall by one percentage point.

Indices

If you’re looking at Gilts, the best known index is probably the FTSE Actuaries Government Securities UK Gilts All Stock Index. It covers pretty much all conventional Gilts that pay a fixed coupon. It’s not adjusted for free floats unlike the Bloomberg Barclays Global Aggregate UK Government Bond Float Adjusted Bond Index. The adjustment for the float means that the Bloomberg Barclays index has slightly outperformed the FTSE index. Both Bloomberg and FTSE offer a huge range of bond indices across the world.

If you want to invest in US Treasuries (government bonds), then the Markit iBoxx indices are the best known.

It’s also worth noting that Bond ETFs don’t tend to buy all the government bonds in a particular index. With so many different bonds, the cost would be huge, so the most common approach is to hold some bonds in the index, also known as ‘sampling.’ The ETF may also use some futures to help reduce the tracking error.

ETFs

Finally, here’s a round-up of a few leading UCITS government bond ETFs.

  1. Biggest – iShares $ Treasury Bonds 1-3 years UCITS USD (LSE: IBTA)

This is comprised of US treasuries with a maturity between 1 and 3 years. Assets under management are just over $2.5 billion and the total expense ratio (TER) is 0.2%. The ETF tracks the Bloomberg Barclays US Treasury 1-3 Year Term Index and does this via physical sampling. Only bonds with a minimum amount outstanding of 2 billion euros are included in the index. The ETF isn’t hedged so UK investors would suffer if the dollar fell against the pound.

iShares run a UK Gilt ETF that isn’t much smaller. It’s the iShares Core UK Gilts UCITS ETF. It has a TER of 0.2%.

  1. Cheapest – Lyxor FTSE Actuaries UK Gilts (LSE: GILS)

This ETF is a cheap way of getting exposure to UK Gilts with a TER of just 0.07%. It tracks the FTSE Actuaries Government Securities UK Gilt All Stock Index. Lyxor offers a range of other Fixed income ETFs that also have a TER of 0.07%

  1. Hedged – db x-trackers II Global Government Bond UCITS ETF 2D (LSE: XGSG)

If you want a one-stop shop for global government bonds, this could be a good option. The ETF tracks the Citi World Government Bond Index which includes bonds issued by 19 countries. The Fund is sterling hedged, so you won’t lose out if sterling rises while you hold the ETF. The fund has 900 million euros under management and a TER of 0.25%.

  1. Inflation-linked – iShares € Inflation Linked Govt Bond UCITS ETF EUR (LSE: IBC1)

If you’re worried about rising inflation eroding the value of your investment in bonds, you can invest in index-linked bonds where the size of the bond’s coupon rises in line with inflation. There are also index-linked bond ETFs.

This iShares ETF gives you exposure to eurozone index-linked bonds. It tracks the Bloomberg Barclays Euro Government Inflation Bond Index. Eligible bonds for the index must have a remaining life of at least one year and have a minimum outstanding of 500 million euros. The TER is 0.25%.

If you wish to find out about Corporate Bond ETFs, read this article.

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