Investing in bonds is traditionally seen as a low-risk way of diversifying your portfolio. And in an era of modest inflation and low interest rates, they've served investors well over the last twenty years.
The argument against bonds now is that we live in a world where interest rates are set to rise, and as that happens, bond values will inevitably fall. There's some truth in that view, but we're already seeing declining enthusiasm for further rate rises in the US this year. And there doesn't seem to be any sign of inflation dramatically picking up any time soon. So maybe we're not going to see any dramatic moves in bond yields, and hence prices, over the next few years.
There's clearly a case for investing some of your portfolio in government and corporate bonds - a.k.a fixed income.
The right vehicle?
But if you do want fixed income in your portfolio - are ETFs the right tools?
Most ETFs are passive, and one concern is that passive bonds funds invest more of their money with the largest borrowers, and those larger borrowers may be less safe than borrowers with smaller debts. There's something in this but I don't think it's a major issue when it comes to government bonds or investment grade corporate bonds.
You see, if you're investing in government bonds, it's extremely unlikely that either the UK or US governments will default and not pay off their debt to bondholders. Admittedly, the risk is higher with some other countries, but perhaps that means you should just avoid an emerging markets bond ETF.
if you're investing in investment-grade corporate bonds, these are bonds issued by companies that are generally pretty safe. So if you spread your investment across a range of investment grade bonds, you probably won't be hit by a large number of defaults in a recession. (No guarantees though.) The risks are higher with high-yield corporate bonds, and if we do head into recession in the next couple of years, the high yield market could be tough. But we're not highlighting any high yield ETFs in this article.
And, anyway, as Oliver Smith from IG Smart Portfolios, points out, active bond fund managers still struggle to beat passive bond ETFs 'even though they [the passive ETFs] may not have optimal weightings.'
Another criticism is that the current range of fixed income ETFs are 'uninspiring', according to Peter Sleep at Seven Investment Management. But even then, Sleep adds that 'they demonstrably do work.'
What's more, fixed income ETFs offer the advantage of low costs and simplicity. Low costs are especially important when it comes to fixed income given that potential returns are more limited than for equities.
ETFs also offer the opportunity to invest in bonds with particular maturities. So, for example, the iShares $ Treasury Bond 7-10yr UCITS ETF gives you exposure to US Government Treasuries which are due to mature within the next seven to ten years. The nice thing is that as some of the bonds' maturities fall below 7 years, the ETF sells those ETFs and invests in ETFs that fall within the ETF's remit. It's all done for you, you don't need to do anything.
I think it's best to go for ETFs that are comprised of pretty mainstream bonds. If you're invested in more mainstream bonds, they should be relatively liquid and hence suffer less in choppy markets.
I'm now going to highlight some of the more attractive fixed income ETFs. But I should stress that they're not right for everyone. Your choice will depend on your own individual circumstances and attitudes to risk. Treat this article as a starting point for your research.
Lyxor Core FTSE Actuaries UCITS ETF (GILS)
This ETF gives you very cheap exposure to UK Gilts - the ongoing charge is just 0.07% a year. It tracks the FTSE Actuaries UK Gilts All Stocks Index, which includes a wide range of conventional gilts of different maturities. The weightings depend on the price of the gilt and the amount of outstanding debt.
iShares offer a similar ETF, the iShares Core UK Gilts UCITS ETF (IGLT). It has a higher ongoing charge at 0.2%, but it's larger than its Lyxor rival so, on the day that you buy, you may find that the bid/offer spread for this iShares ETF is tighter.
I said earlier in the article that a significant rise in inflation didn't seem likely in the near future. The UK is a possible exception to that. If we have a no-deal Brexit at the end of March, sterling could tumble which, in turn, could trigger inflation. In those circumstances, this ETF could prove to be a poor investment.
If you're worried about the inflation threat, you could go for the second ETF in this list.
Lyxor FTSE Actuaries UK Gilts Inflation-Linked UCITS ETF (GILI)
This Lyxor ETF (GILI) is very similar to (GILS) above except it is comprised of index-linked gilts, so you'll be protected if inflation takes off. It has the same 0.07% ongoing charge.
iShares Core ¬£ Corporate Bonds UCITS (SLXX)
This ETF gives you access to a range of Corporate Bonds issues by companies in sterling. The ETF tracks the Markit iBoxx GBP Liquid Corporates Large Cap Index which comprises liquid, investment grade bonds issued by large companies.
You might think these companies would mostly be in the FTSE 100, but the ETF includes bonds issued by companies that are neither based in the UK nor listed there. The top ten holdings in the ETF include bonds from Walmart and Bank of America as well as Barclays. The ongoing charge is 0.2% a year.
Investing in Corporate Bonds is riskier than gilts or treasuries, but as these are investment grade bonds, the risk of default is still on the low side. Of course, a significant rise in inflation or interest rates would hit performance.
iShares Global Corporate Bond UCITS ETF USD (CORP)
This ETF tracks the Barclays Global Aggregate Corporate Bond Index which gives you exposure to a wide range of investment-grade corporate bonds in different currencies around the world. As well as buying corporate bonds, the fund also invests in some government bonds which, according to iShares, helps the ETF achieve its investment objectives with appropriate risk.
The point about this ETF is that it diversifies you away from sterling. Around two thirds of the fund is invested in dollar-denominated bonds; about 23% in euros, and around 5% in sterling. The ongoing charge is 0.2%.
Depending on what happens with Brexit, we may see some sizeable moves in sterling over the next couple of years. It's impossible to predict the outcome, but it definitely makes sense to diversify away from Sterling.
Of course, the other big risk for global bonds is that US rates rise more quickly than I currently expect. That might happen if the US economy starts to overheat following Trump's tax cuts a year ago. I'm not ruling that scenario out completely, but it doesn't seem very likely to me in 2019.
iShares $ Treasury Bond 1-3 year UCITS ETF USD
This ETF gives you pure exposure to US government bonds (Treasuries). It tracks an index comprised of US Treasuries with a maturity between 1 and 3 years. Going for bonds with short maturity reduces the risk, but you could still get caught out if the dollar moves against you - in other words, a fall against sterling or whatever your 'home' currency may be.
So that's five fixed income ETFs to look at. There are plenty of other good ones out there. If you focus on the Lyxor and iShares ranges, you should find a good range with low fees and decent liquidity.