Everything investors need to know about income ETFs

For investors in Australia and globally, the volume of exchange-traded products and the assets within them continue to soar. While those focused on stocks grab most of the attention, there’s also a growing cohort of investors using these vehicles to invest for income.

In the following, we consider some of the most important things to be aware of and how investors can find some of the best income investing opportunities in the space.

For those who are beginners, how do fixed income ETFs work?

VanEck Portfolio Manager Cameron McCormack tackles this question at the base, by explaining fixed income securities, which most commonly take the form of bonds.

“Governments and corporations can raise capital by issuing bonds to the market, and these bonds are assigned a credit quality rating from firms such as S&P, Moody’s and Fitch,” he says.

“Investors who purchase bonds are essentially lending to the government or corporation that issued them. In return, they receive interest in regular instalments (known as ‘coupons’) that are based on a fixed or floating rate.

“Each fixed income ETF focuses on a particular investment strategy and holds a collection of securities that meet the criteria. In some cases, a fixed income ETF can hold over 100 securities.”

What are the pros and cons of using ETFs to get exposure to income-generating assets?

McCormack believes ETFs are especially beneficial for gaining exposure to international bonds. That’s because they’re the most difficult for retail investors to access and generally have higher minimum investment amounts.

He notes the ETF structure is also an easier way to access locally issued bonds that tend to only be available to institutional investors, such as subordinated debt.

“Bond ETFs trade on exchanges, which makes investing as simple and accessible as buying a stock. Investors also get exposure to a diversified portfolio of bonds that can align with their investment goals, risk tolerance and income requirements,” McCormack says.

Price discovery is another advantage he calls out – while noting this can also be regarded as an argument against bond ETFs.

“For example, in March 2020 some bond ETFs experienced wider buy/sell spreads. This is because, as liquidity in the underlying over the counter (OTC) bond market dried up, spreads widened to reflect the lower (discounted) prices the underlying bonds could trade for OTC,” McCormack says.

“This was then reflected in the price of the ETF as a discount to the Net Asset Value (NAV) of the fund’s underlying holdings.”

Conceding some see this as a weakness of fixed income ETFs, “we think it’s an advantage,” McCormack says, pointing to a Wall Street Journal article, “ETFs Have Passed Their COVID-19 Stress Test.”

“Bond ETFs were more of a reflection of where the OTC bond market was at, and that bond prices ‘need(ed) to catch up’ to the ETFs’ prices.”

He also cites a Financial Times article that makes a similar point: “Moreover, the discounts meant that sellers of the ETF bore the cost of instant liquidity, rather than the remaining investors in the fund. This is a fairer outcome than what happens with traditional bond funds, which often sell their most liquid, higher-quality assets to accommodate outflows, leaving remaining investors holding an inferior portfolio.” 

What is the number one thing investors frequently misunderstand about using ETFs for income versus growth?

The “fixed” in the “fixed income” terminology doesn’t mean the distributions you receive will be regular and consistent.

“Investors frequently underestimate the importance of smooth distributions when using ETFs for income, and it’s an omission that can potentially cost them dearly,” McCormack says.

Irregular or inconsistent distributions can result from income-oriented ETFs, “especially with strategies that have overseas exposure and are ‘hedged’ to the Australian dollar”.

“A good example of this are ETFs based on asset classes like global real estate and global infrastructure. Investors expect smooth and consistent distributions, but they can often be disappointed with the income outcome they receive,” McCormack says.

Steps have been taken by some ETF issuers to help address this issue, including adopting Taxation of Financial Arrangements (ToFA) legislation. A radical shift in the way currency-hedged funds are taxed, “this should mean bumpy distributions should be a thing of the past. But it is difficult to implement, so many do not,” McCormack says.

He points to another recent tax change known as Attribution Managed Investment Trust (AMIT), which was introduced in 2016. This gave ETF issuers the ability to smooth out distributions.

“Again, implementation requires knowledge of complex tax rules,” McCormack says.

“Very few funds are actively implementing these tax changes, despite being more beneficial for income seeking investors. This is where the skill and experience of the ETF issuer is important. Investors should look at the fund’s dividend experience before believing any representations.”

How has the breadth of fixed income ETFs available in Australia changed over the past few years?

In short, there are more opportunities in this space for Australian investors now than there were two years ago. This includes access to subordinated debt, Australian government bonds, and US Treasury bonds.

The ASX listed 17 new fixed income ETFs during 2023 and 2024 (to the end of May 2024), according to Rory Cunningham, ASX’s Senior Manager, Business Development, Investment Products.

“The new listings were across a broad range of fixed income strategies, regions and sub-asset classes,” Cunningham says. Examples include:

• Short, medium and long-dated Australian government and US treasury bonds,
• ETFs that provide geared long and short exposure to fixed income markets,
• Active and absolute return strategies, and
• Sustainable bonds.

VanEck’s McCormack says the biggest growth among fixed income ETFs is in those providing exposure to the global market, which has more than doubled to 27 in the last two years.

What role do income ETFs typically play within a retail investors’ portfolio?

As McCormack explains, fixed income ETFs are most often used to diversify an investment portfolio.

“As bonds and equities have traditionally been lowly correlated, investors have used bonds to ‘cushion’ losses from higher-risk equities when the stock market dips,” he says.

“This diversification benefit can also apply across markets. Emerging market income ETFs give investors access to a diversified portfolio of bonds and currencies in countries with relative fiscal strength versus developed markets that are highly indebted.”

He also notes that the “stable and steady” long-term income streams fixed income ETFs offer mean they are often used as defensive assets.

“The lower risk compared to a growth fund is due to the underlying securities, which typically come from investment-grade issuers like governments and banks.

"Bonds are also higher up in the capital structure, which means that in the event of liquidation, these debts are paid out before common equity.”

What is driving Australian investors’ demand for listed fixed income funds?

ASX’s Cunningham says there are three core reasons: 

“An environment of higher interest rates, coupled with relatively more certainty regarding central bank cash rates, means bonds are attractive to investors.”

Demographics also play a role, with an increasing number of investors in Australia entering retirement phase. “As such, they may be looking to increase their fixed income exposure as their portfolio becomes more conservative over time,” says Cunningham.

He also points to the ongoing rise in popularity of ETFs among financial advisers, who, “already understand the role of fixed income in a portfolio, so they are likely to be adopters of fixed income ETFs.”

VanEck’s McCormack also notes the “higher for longer” interest rate environment, coupled with fears of recession and company earnings revisions, have seen investors and financial advisers shift money back into bonds.

“In particular, higher-yielding corporate bonds, which may offer less potential downside risks than equities, have given Australian investors a compelling yield opportunity,” he says.

“The yield on bonds is closer to, or in some instances higher, than the rates at the long end of the curve. Further, the price of incremental risk of rate rises in fixed-income markets has de-compressed.”

“Higher yields means that ‘carry’ (which is the difference between price losses and the income) is once again providing fixed-income investors with a cushion,” McCormack says.

“The income earned on the current 10-year Australian Government bond note provides a return buffer that would allow investors to break even, even if the yield increases by 43 bps to 4.41% over the next 12 months.”

Coming back to where we started, what advice would you give investors who are just starting to look at this space?

Professional financial advice should be your starting point, says McCormack.

“Investors should also do their own research: just because it appears cheap, doesn’t mean it’s a worthwhile investment. Understand the underlying exposure and intended investment outcome,” he says.

“For ETFs that track an index, it’s important to firstly check whether the index aligns with the investor’s desired investment goals, risk appetite and income needs, and secondly check that the index it is tracking is the best way to do this.”

He also emphasises the importance of fund manager skill in tracking the ETF index.

“Investors should seek a fund manager with a history of tracking their respective fund indices closely, which means the returns should be within just a few basis points of the index after adjusting for fees,” McCormack says.

“ETF issuers that have a thorough understanding of the capital markets and tax rules is vital, particularly when seeking an income-oriented investment outcome, as investing in overseas markets and hedging returns back to Australian dollars can be difficult.”

Some other ways to assess the ETF asset manager include:

• understand their history and how long they have been investing money,
• consider how long they have been issuing ETFs, including both here and overseas, and
• try to appreciate their commitment to investors and the quality of their products.

Learn more about Income Investing from VanEck here.