What makes a good bond ETF?

Commentary by David Hsu, senior equity index and ETF product specialist, and Kelly Gemmell, investment product manager, Vanguard, Europe.

• Bonds can play the key role of stabiliser in a balanced portfolio of investments.
• One way to acquire this type of exposure is via an ETF, which seeks to provide investors with low-cost, simple and liquid access to the vast global fixed income universe.
• Investors need to carefully consider how their bond ETF is constructed and managed to get the best from the asset class.

As well as providing total return and income, bonds can play the key role of stabiliser in a balanced spread of investments. By adding ballast to portfolios, bonds can bring a stability to returns across the ebb and flow of the market cycle. One way to acquire this type of exposure is via an ETF, which seeks to provide investors with low-cost, simple and liquid access to the vast global fixed income universe.

It’s all about trade-off

The scale of the fixed income market—larger than $125 trillion¹ globally and growing fast—nevertheless presents a challenge to providers. Indexing with a larger number of securities is more labour-intensive than with a smaller number, so bond ETFs are more difficult to manage. The sheer size of the target indices, combined with the over-the-counter (OTC) nature of bond markets and the fact that some bond issues are difficult to purchase, means that fully replicating a fixed income benchmark is usually not cost effective and can be disadvantageous in terms of liquidity.

Investors need to have exposure to as wide a representation of the index as possible as this brings a higher chance of diversified beta—that is, exposure to the broad market—and ultimately investment success. The best bond ETFs, therefore, are those that can most closely match the performance and market exposure of the benchmark index at the lowest possible cost.

A snapshot of the universe

Most bond ETF fund managers tackle this by sampling the index: investing in a representative cross-section of the bonds that make up the universe. The sample is intended to match the key risk characteristics of the index, namely sectors, currencies, credit quality, capital structure and duration. This allows the ETF to replicate the intended risk of the index as well as to track its returns.

Using this approach, a bond ETF can condense an index made up of tens of thousands of individual securities into a portfolio of a few thousand bonds, all the while accurately tracking the performance and other key features of the benchmark. It also allows the ETF to typically have a higher liquidity profile than the index that it tracks, which is a key advantage for balanced investors.

Passive but at the same time highly active

For sampling to be truly effective, in-depth credit research is needed, which in turn requires experienced teams of specialists to evaluate the creditworthiness and relative value of both corporate and government bond issuers. And diligent research is arguably even more important with regard to a bond ETF than with its equity equivalent as the asymmetry of bond returns—particularly in the corporate bond market—exposes investors to limited upside but potentially significant loss of capital in the case of default.  

Scale and resources are vital

As fixed income proliferates into an increasing spread of world markets, it takes a global team of fixed income professionals to create an optimised portfolio by selecting the right high-quality mix of bonds that, combined, will broadly replicate the essential risk and return features of the benchmark without causing costs to become too high. It’s a highly intensive methodology that demands significant economies of scale to succeed consistently.

So when choosing a Vanguard bond ETF, you have the peace of mind your investment is being managed by our dedicated Fixed Income Group. With around 190 professionals, including over 50 focused on credit research, we have one of the biggest global teams in the industry, overseeing US$1.8 trillion of assets. 

Our refined, developed process, which has been enhanced over decades, has continually delivered for our investors over multiple market cycles. As much as any other product in the Vanguard range, our bond ETFs adhere rigidly to our core client-focused philosophy: high quality and low cost.

¹ Source: International Capital Market Association (ICMA). As at August 2020, ICMA estimated that the overall size of the global bond markets in terms of USD equivalent notional outstanding was approximately $128.3 trillion. https://www.icmagroup.org/market-practice-and-regulatory-policy/secondary-markets/bond-market-size/