Australia's best bond ETFs

The benefits of diversification are well known, in that it lowers portfolio risk, stabilises your returns, and helps you achieve better long-term results. One asset class that provides great diversification benefits is bonds.

Bonds are issued by governments or corporations to raise cash, and all bonds have a face value, coupon interest rate, and maturity date.

The bonds issued by the Australian government are considered highly secure investments, as Australia is one of only 11 countries to have its bonds rated AAA.

Benefits of Bonds

One of the biggest benefits of bonds, is in the risk management. While the share market can rise or fall by up to 20% or more in a year, the value of bonds is not tied to the direction of the share market, but rather bonds have an inverse relationship with interest rates. So, if the share market is falling, having bonds in your portfolio will often help cushion the fall.

Another important benefit of bonds is that if you decide to hold the bond to maturity, the face value of the bond will be returned to you. So, assuming there is no default, and you hold the bond to maturity, you won’t lose any capital.

Another advantage of bonds is that investors receive interest payments along the way, which when calculated on an annual basis, is the face value of the bond multiplied by the coupon interest rate, which are both set at the time of the bond’s issuance.

Different to say a term deposit, the market price of existing bonds will fluctuate and move in the opposite direction to interest rates. However, as the bond approaches its maturity date, the bond price will also approach its face value (as the bond’s face value will be returned to the bond holder at maturity).

So, what is happening in the bond market at the moment?

Today’s Bond Environment

Firstly, let’s take a look back at 2022. With inflation sky high and interest rates rising sharply throughout the year, it resulted in one of the worst years on record for bond valuations. In fact, in 2022 in the US, long dated 30-year bonds lost 39.2% in value, which is a record low dating back to when data was first collected in 1754.

One way to explain why bond values drop when interest rates rise, is as follows. As coupon interest rates (and thus yields) increase on new bond issues, the yields on existing bonds become less attractive. Hence, existing bonds are sold down, which has the effect of lowering the bond’s market price. This then increases the existing bond’s running yield (which is calculated as the bond’s coupon payment divided by its market price).

With inflation now falling and interest rates forecast to be cut several times during 2024, the opposite may now occur, in that existing bonds could be ‘bought up’ due to their attractive yield. As such, many commentators believe that 2024 could be a good year for bonds.

Indeed, bonds have already rallied somewhat, with bond ETFs such as IAF (iShares Core Composite Bond ETF) up around 5% since the start of November 2023.

The decision to own bonds in your investment portfolio makes a lot of sense, and one of the best ways to own bonds is via a diversified bonds ETF.

The best Australian Bond ETFs

We have selected five bond ETFs that we believe are good investments.

In selecting the list, we have focused on key criteria such as diversification levels, MER (Management Expense Ratio), the quality of the investment manager, fund size, liquidity, tracking error, and performance.

When viewing the performance of the ETFs in the table below, it can be noticed that performance has not been great over say the last 3 years. This performance however will likely improve, especially if interest rates are cut as predicted.

This is a good time to remember that past performance is not always a good indicator of future performance.

The following table summarises the Performance (total return) of each ETF as of 31 December 2023.

Ishares Core Composite Bond ETF (IAF)

IAF is managed by Blackrock which is the biggest ETF manager in the world.

The ETF listed in March 2012, and is a diversified portfolio of 598 bond holdings which include Australian Government Bonds (51.7%), State Government related bonds (39.4%) and corporate bonds (8.5%).

Distributions to investors occur quarterly, and the fund is rebalanced on a monthly basis.

The ETF has a running yield of 2.93%, and a weighted average maturity date of 5.96 years.

IAF is the biggest bond ETF in Australia by fund size.

Vanguard Australian Fixed Interest Index ETF (VAF)

Similar to IAF, this ETF tracks the Bloomberg AusBond Composite 0 Yr Index, and as such has a similar portfolio of bonds, and a similar performance to IAF.

This ETF has 706 holdings and provides high diversification, with an average bond rating of AA .

The fund is suitable for an investor with a medium-term investment horizon and is seeking a steady and reliable income stream.

Over the past 12 months, both IAF and VAF have reduced their fees to 0.10% as they compete for investor’s funds.

Vanguard Australian Government Bond Index ETF (VGB)

VGB invests in high-quality bonds issued by the Commonwealth Government of Australia, Australian State Government authorities, and treasury corporations.

The ETF is very low risk, with 77.3% of the bonds rated AAA and 22.7% of the bonds rated AA.

The ETF has 155 holdings, and a slightly higher management fee of 0.20%. Income for the ETF is distributed quarterly, and the bonds have a running yield of 2.86%, and an average weighted maturity date of 6.5 years.

Australian Investment Grade Corporate Bond ETF (CRED)

This Bond ETF is made up exclusively of corporate bonds. As such, the ETF is higher risk with bond ratings ranging from AAA to BBB-, with the average bond rating around the BBB mark.

Investors are compensated for this higher risk with slightly better performance results, and CRED’s running yield is currently at 4.50%.

The ETF’s bond sector allocations are Financials 34.8%, Industrials 17.5%, Utilities 15.4%, Consumer Non-Cyclical 14.0%, Communications 11.4%, Consumer Cyclical 6.8%. 

Vanguard Global Aggregate Bond Index (Hedged) ETF (VBND)

This ETF provides enormous diversification, as it holds 11,754 bond holdings from across 60 countries. The ETF seeks to track the Bloomberg Global Aggregate Float-Adjusted and Scaled Index, hedged into Australian dollars before taking into account fees, expenses and tax.

The bonds are high quality and have an average risk rating of AA-.

The ETF contains bonds from North America 49.3%, Europe 30.3%, Pacific 11.5%, Emerging Markets 5.5%, Other 3.3%, and Middle East 0.2%.

Summary

Bond ETFs are a vital part of any balanced investment portfolio, and provide the important qualities of asset class diversification, preservation of capital, and a constant stream of regular distributions.

As such, InvestSMART has included both IAF and VBND in many of InvestSMART’s diversified ETF portfolios.