I always have my reservation of investing bonds using a Bond ETF. The bond market is a big boys game, it is dominated by large financial institutional players, which means retail investors like you and I have nearly no “edge” when playing the same game.
When Astrea IV bond was launched last month, I knew it would become popular. Not because how fantastic this product was, but the mere hunger of seeking for yield and ignorance of most retail investors when it comes to bond investing.
Investors always forget that they are the counterparty of a financial product’s issuer. The more investors gain, the less to the product provider. The retail tranche of Class A-1 Astrea bonds carries an interest rate of 4.35%. So why such a high interest if it is so good?
Anyway, Astrea IV bond is not today’s topic. The latest buzz in town is Nikko AM SGD Investment Grade Corporate Bond ETF. If you google it, you will see a lot of praise for the product:
- No currency risk – first 100% SGD dominated bond
- Safety of the issuer (familiar names actually) – The Index comprises bonds issued by established and credible institutions such as sovereign wealth fund Temasek Financial and statutory boards such as the Housing Development Board (HDB), the Land Transport Authority (LTA), and the Public Utilities Board (PUB).
- Low cost – ETF is a cheaper vehicle comparing to most unit trusts
Since most investors are familiar with stock IPOs, the fund manager even launched an IPO of the bond ETF (The IPO price has no practical meaning to the investor as it is just an asset gathering process).
As a start, most people have some misunderstandings about stock ETFs, so it is no surprise to see the public confusion when it comes to an “Investment Grade Corporate Bond ETF”. I will debunk three myths of Bond ETF Investing in this article, so you can make a better investment decision.
What is a Corporate Bond ETF
Traditionally, bond investment is used as an alternative to stock investment, especially when the stock market is volatile.
You can think about bond investing like this: when you take a mortgage loan, the bank lends the money to you, and you pay the bank the interest and the principal. In this process, you are the “issuer” and the bank is your “creditor”.
When you purchase a corporate bond, it is the reversed process. You lend your money to a company, and the company pays you back the interest and principal over the years. In this process, the company is the “issuer” and you are the “creditor”.
In the past, Singapore has a sluggish retail bond market. Bond investments are mostly for financial institutions or high-net-worth individuals because the typical minimum investment of a bond is $250,000. A bond fund aims to solve this problem.
When you buy a bond fund, you are like conducting a “group-buy” in Taobao. The fund manager gathers the money from a group of investors and buys a basket of individual bonds. In return, each investor gets his own share of the weighted average returns of the underlying bonds. There are two types of bond funds:
- Bond Unit Trust Fund (UT)
- Bond Exchange Traded Fund (ETF)
Myth #1: Bond ETF means lower cost
According to the product sheet of Nikko AM SGD Investment Grade Corporate Bond ETF, The Total Expense ratio of the fund is capped at 0.30% p.a. for at least 3 years from inception.
From a quick search on Fundsupermart, you can see that most Singapore fixed income funds have Annual Expense Ratio from 0.62% to 1.27%.
At a glance, it seems Bond ETF is a cheaper option. But what ETF provider does is to “externalize” the cost which is reflected in a bond unit trust expense ratio. In practice, when you buy an ETF, you need to get it from an exchange and you have to pay a few other fees:
- Broker Fee for both buy and sell: a typical Singapore broker fee is 0.275% (min $25) or 0.08% (min $10) if you use an online platform such as Fundsupermart
- CDP Clearing Fee: 0.0325%
- SGX Trading Fee: 0.0075%
- GST on top of all the fees
- Bid-offer spread from the market
- Slippage from the market maker (if you know what it is)
The table above also shows that smaller funds tend to have a higher expense ratio. For example, the same manager Nikko AM’s own unit trust has an expense ratio of 1.27%.
Myth #2: Bond ETF means passive investing
In my article about the 3 myths of stock ETF investing, I have highlighted that there is no true passive investing fund. There is a security selection process for every fund, be it a unit trust or ETF.
Nikko AM SGD Investment Grade Corporate Bond ETF tracks iBoxx SGD Non-Sovereigns Large Cap Investment Grade Index. Actually, they are the only user of the index. This is unlike the S&P 500 Index which is widely used by many market participants.
According to Markit iBoxx (the index issuer) and Nikko AM (the ETF provider), this index tracks the performance of SGD denominated investment grade bonds excluding Singapore Government Securities, whilst upholding minimum standards of investability and liquidity.
The portfolio will invest your money with the following rules:
- The ETF consists of 102 bonds with 45 issuers
- Minimum outstanding: SGD300 million
- Average credit rating: A
- Yield to maturity: 3.22% p.a.
- Modified duration: 4.68 years
- Single issuer limit:
- 20% for rated Statutory Boards
- 10% for rated issuers
- 5% for unrated issuers
- 20% Group limit
The bond index is dominated by Singapore statutory boards, financials and property sectors, it also has active issuers from other sectors and countries. Foreign issuers account for over 20% of the Index.
I won’t go through the technicality of this, but what you need to know is that the selection process is largely determined by the index provider IHS Markit’s proprietary “Implied Rating classification” model. And this way of investing is what most active bond fund managers do. So I would argue this is a semi-active approach.
Myth #3: Bond ETFs are safe
You may be thinking of buy-and-hold a bond ETF for long-term, say for your retirement income.
First of all, buy and hold doesn’t work in the real world.
Secondly, due to the prolonged interest rate environment, few investors have first-hand experience to understand the impact of rising interest rate.
When the interest rate goes up, it may not be clear whether a stock price will go up or down, but the bond price will drop, for sure. This is not a prediction or gut feeling, but the mathematics of how the bond is valued.
If you buy an individual bond, this is not a big issue because you can hold the bond till maturity and you will get back your principal at the maturity date as long as the issuer doesn’t default. But this is not the case for Bond ETF.
In bond investing, there is an important term called “duration”, it measures how sensitive a bond is to changes in prevailing interest rates. By multiplying a bond’s duration by the change, you can estimate the percentage price change for the bond.
For example, if a bond has a duration of 5 years and the interest rate increases by 20 basis points (0.25%), the approximate percentage change in the bond’s price would be:
-5 x .0025 = -0.0125 or -1.25% (Note it is negative 1.25%)
The chart below of two popular bond ETFs testifies this:
- Nikko AM ABF Singapore Bond Index Fund: tracks the index of bonds issued by mainly Singapore government and other agencies.
- iShares Core U.S. Aggregate Bond ETF: tracks the index composed of the total U.S. investment-grade bond market.
Despite the safety (investment grade) of the underlying bonds, both ETFs dropped 5% to 6% in the past 2 years. Can your bond coupon cover this loss? With a 2% to 3% kind of interest and all the costs of investing in an ETF, you won’t be able to make any money by investing in these types of Bond ETF.
If you have a portfolio of bonds, you should take a look at the historical price of your holdings. Are you losing money unknowingly?
According to the product sheet, the modified duration of the bond ETF is 4.7 years (You don’t have to bother how this is calculated). It means if the interest rate goes up 1%, you will lose approximately 4.7%. The current yield of the index is 3.22%, and you can do your own math.
On contrary, an active bond unit trust fund manager can do a much better job by hedging the interest rate risks (at a cost though). But my belief is that you should be better off investing in an active bond fund than bond ETF in a rising interest rate environment.
To be honest, Nikko AM SGD Investment Grade Corporate Bond ETF is an innovative product. An SGD Investment Corporate Bond Portfolio fills up the gap of the requirement for small institutional investors or high net-worth individuals who have the mandate to invest in SGD dominated bonds.
In my newly launched book “F.I.R.E. Your Retirement“, I also explained how bonds can help supplement CPF Life to provide an additional layer of passive income. But you need to be careful about how you invest in bonds.
When I conduct the investment portfolio review for my clients, I notice that many investors have bought “Nikko AM ABF Singapore Bond Index ETF” from their banks or brokers. The ETF is good and it does what it has promised. But I hope after reading this article, you can ask yourself these questions:
- Does bond investment still make sense in a rising interest rate environment? If so, what type of bonds should you invest?
- Is bond ETF the best instrument to use? If not, what are the alternatives?
Do you have any question about bond investment? Leave your comment below and I will answer them all.