Income and diversification can have a one stop solution

Income is an important part of every investor’s portfolio. In the current higher rate environment, bonds are back in fashion and providing investors with returns diversified from equities and other asset classes.

But when looking to allocating capital to bonds, diversification is key if you’re not a bond expert, says John Caulfield, Director, Intermediaries and Institutions at VanEck Australia:

Individual bonds are riskier than investing in individual stocks. From a retail perspective being able to access the bonds in terms of the parcel size is one thing. The diversification or concentration risk in an individual bond is just far greater. Taking an ETF approach gives you instant diversification.

Bonds are tricky. Not everybody understands them completely. How interest rates work, whether rates are dropping, and prices are rising or vice versa. It's a little more counterintuitive. Equities are more easily understood.

In this video, Caulfield explains why bonds merit investors’ consideration, but also why a bond ETF might be a better-diversified solution.

Edited transcript

What's your outlook for bonds? 

Caulfield: Bonds are back in fashion. You're certainly getting paid to hold fixed income. If you cast your mind back to the COVID period when we had zero rates, it was often referred to as return-free risk. There was no yield on offer. You were holding interest rate duration or interest rate risk. We knew rates were going to rise at some point. I don't think anybody really realised how soon or how quickly things would move. 

What that has meant is that you now have an opportunity to have bonds behaving in a more traditional, conventional way in portfolios: uncorrelated asset to equities. If we see an equity sell off and rates do come down, you will see bonds appreciate in value.

Why should investors be considering them right now? 

Caulfield: Bonds will offer you a degree of stability relative to equities, being a more defensive asset class, and behaving in a more defensive manner than they have over previous two, three years. 

They give people the option of being quite patient whilst they wait to see what risks play out and what opportunities may present next year. 

What role do bonds play in a retail investor's portfolio?

Caulfield: Income is important to a range of retail investors. Whether you are in accumulation or in pension phase, everybody needs some income. 

Investors were forced into alternative asset classes for income historically when we had rates that were at record lows for extended periods; increased levels of risk for the income required. That has shifted back to bonds providing yield. Bonds providing you some sort of income and you're not necessarily needing to stretch into equities or even private markets looking for some alternative sources of return.

What are the pros and cons of investing in separate bonds versus investing in bond ETFs

Caulfield: Individual bonds are riskier than investing in individual stocks. From a retail perspective being able to access the bonds in terms of the parcel size is one thing. The diversification or concentration risk in an individual bond is just far greater. Taking an ETF approach gives you instant diversification. Aussie government bonds have a range of maturities; corporate bonds will be across sectors. You really do just reduce your, your risk of concentration from owning something individual. 

People don't necessarily have the same expertise in terms of analysing a bond or a credit instrument as they potentially do with equities. With equities, there is the familiarity of this asset class, there's the reliance on external research. 

Bonds are tricky. Not everybody understands them completely. How interest rates work, whether rates are dropping, and prices are rising or vice versa. It's a little more counterintuitive. Equities are more easily understood.

The way fixed rate coupon bonds work: you are given a certain coupon and if rates rise from there, that coupon becomes less appealing because rates are obviously higher, so the price of the bond will drop to reflect that. You see rates up, but the price or the value of your bond reduce. People aren't necessarily expecting that sort of relationship when they look at portfolios and can be caught a little bit unaware with some of those risks.

What are the important features of ETFs for investors to be aware of? 

Caulfield: ETFs bring you transparency. They bring you diversification. But they also bring you granularity. And I think that's where we've seen a lot of flow and a lot of interest from investors over the last 18 to 24 months, particularly in the fixed income space where investors have said, "I want to target a specific duration." It may be floating rate over fixed rate, it may be corporate bonds over government bonds. 

Whereas if you're just in a very broad managed fund, you may be exposed to an entire asset class if you like, and you're not beholden to whatever strategy, that remit is. Whereas with the ETF there is a proliferation of more options. People can certainly be more specific around the sort of yield credit quality-duration trade off. 

We offer funds that focus on, call it specific sub-asset classes: various floating rate node exposures, some fixed rate Aussie corporates, some Aussie government bonds only. So you can be a little bit more specific around the sub-asset class,

Access a portfolio of Australian government bonds which have maturity dates between 1 and 20 years with 1GOV, 5 GOV and XGOV

ETF

Vaneck 1-5 Year Australian Government Bond ETF (1GOV)

Australian Fixed Income

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ETF

Vaneck 5-10 Year Australian Government Bond ETF (5GOV)

Australian Fixed Income

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ETF

Vaneck 10+ Year Australian Government Bond ETF (XGOV)

Australian Fixed Income

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