If you are invested in a passive portfolio of ETF, chances are you will have doubts how a persistent secular rise in interest rate may mean you losing money on your bond allocations.
I been wonder for this for some time, and the problem is that we are so pre-occupied that bond is rather fucked in such an environment that whether the base is really not all that bad.
ABF Singapore Bond Index Fund
Currently in Singapore there is only 1 bond ETF which is the Nikko ABF Singapore Bond Index Fund ETF.
It is probably your only choice to do passive investing in a equity and bond portfolio with the STI ETF (equity portion)
This bond ETF is listed on the SGX exchange and you can buy and sell it like your normal stocks through your POEMS, Kim Eng or Standard Chartered Online Trading brokerage.
It tracks the iBoxx ABF Singapore Bond Index which is an indicator of investment returns of S$ denominated debt obligations issues or guaranteed by
- The Singapore Government (or any other Asian government)
- A Singapore Government Agency
- Quasi Singapore Government Agency
- Supranational financial institution
The quality of the holdings are high. The top holdings are bonds issued by
- PSA Corp
- Singapore Government
- SP Power
- Temasek Financial
Current portfolio duration is roughly 6.1 years and yield to maturity is 2.27% (Always changing based on the composition of the index)
Role of a bond ETF in your passive portfolio
There will be time to time different asset classes becomes volatile, and if you have low correlated assets, they take turns to do better than the other.
This means that when your STI ETF is losing ground, your Bond ETF will generate positive returns to offset them.
Bonds and Equities are usually 2 asset classes use as primary ingredients because of the low correlations.
And in recent times this Singapore bond ETF seems to show remarkable low correlations to most other indexes of other asset classes.
Lower volatility in a 50/50 portfolio
A 50% STI ETF/50% ABF bond portfolio will ensure that you are down 18% compare to 42% of your Wealth Fund.
Some folks tend to overestimate their risk tolerance and a more conservative portfolio such as this can increase the chances of them keeping on the wealth building plan.
Interest Rate Up Bond Prices Down
The bond price are rather inverse in relationship with the prevailing interest rate.
If you own a 10 year bond yielding 2% with a price of $1 and the newly issued bond yields 2.5%, why would people buy your 2% bond at $1?
You can only sell it at below $1.
The relation ship is vice versa.
Long Term Bond Trends
This year was the year where the stock markets got wobbly on the news that the Federal reserve may for the first time look to raise interest rate.
The consensus from most of the smart guys is that the trend might be turning soon. The bond yields are likely to revert upwards.
Based on this, on paper it does not bode well for bonds in general.
Differences between bond funds, bond ETF and individual bonds
The differences between the 3 types are larger compare to their equity cousins.
An individual bond can be purchased and you can buy and sell it on a market, or you can choose to hold it to maturity to enjoy the payout initially agreed.
If you hold your bond to maturity, you do not lose any money, unless along the way the bond issuer defaults because they are not financially strong enough to pay you your yield.
Bond unit trusts / mutual funds
Bond funds or bond unit trust / mutual funds are managed by active managers. These active managers will actively buy and sell these bonds based on their expertise.
As investors in these bond funds you have no idea what the managers are doing.
If the managers are competent they may be able to swim well in this very challenging environment, if they are not odds are the bond funds are going to not be the best place to put your money.
A bond exchange traded fund differs from a bond unit trust in that the majority of them (caveat: depends on the Bond ETF policy as well) hold the individual bonds in the ETF to maturity.
Technically not to maturity. What I understand from Nikko AM is that they tend to sell off their maturing bonds (those with duration < 1 year) and use the sum to buy a new long duration bonds.
Bonds that are near maturity are stable in prices since there are not much yield embedded in the prices. If you sell of near maturity bonds, the bond ETF intrinsically do not suffer much losses.
This way it becomes
- Sell of < 1 year duration bonds (low yield to maturity)
- Buy > 5 years duration bonds (if interest rate rises, yield to maturity should be greater than current portfolio yield, if interest rate drops, the opposite happens)
In short, ABF Singapore Bond Index Fund tends to be rather mechanical. What you see is what you get unlike a bond unit trust where you may get positive or negative surprises.
Negative NAV but gaining in Total Returns
Although we want low correlations, at the end of the day, we want all asset classes in our portfolio to eventually end up appreciating.
What good is it if the equity ETF portion makes money and the bond ETF 20 years later ends up negative.
Technically if for the next 20 years the interest rate trends up, the current portfolio holdings should fall in prices.
But it is also true that the distribution of the bond ETF should go up (i.e your yield expands from 2.27% now to perhaps 5%)
Blackrock, one of the largest ETF houses in the world have a good brochure that explains this (Read here)
Specifically they look at a period where interest rate have been trending upwards.
A case study of an individual bond
We hope the previous section explains the need to look at this from a total return angle. On an individual bond basis, its even harder to lose money to rising rate.
As long as you hold the bond to maturity, and provided the issuer of the bond do not stop paying you ( this is called a bond default), when the bond matures they will return you 100% of your money.
Indexology have a good article explaining bonds in a rising rate environment:
The case here is a person who holds a single 10 year treasury bond to maturity. So if he buys it in 2015 it matures in 2025. Coincidentally, during this period, rates starts rising! His world will be crashing down. His opportunity cost of leaving the money in this bond, is that the bonds of the same risk newly being issued now gives him a higher yield.
The chart above shows that at 2025, he didn’t end up losing money. In fact the risk adjusted returns was decent. So why are there so much noise?
If it is possible to make money with bonds when interest rates rise, why are so many people worried that rates will rise? The blue line at the bottom of the chart plots the price of the bond for the same time pattern of rising interest rates. Just as the math requires, rising rates mean lower bond prices. At maturity approaches the price approaches the par value of the bond – the principal to be repaid at maturity. If an investor didn’t reinvest the coupons, if instead he spent the coupon income, all he would have at maturity is the par value. Likewise, if the investor had sold out at the low point on the green line (July 15, 2016) the proceeds for the $100 invested would have been $96.50, a loss of $3.50.
The key here is to recycle the wealth and reinvest it consistently.
Cullen Roche of Pragmatic Capitalism also tries to debunks this rising interest rate is bad for bonds theory:
Rising rates do not necessarily mean negative returns for bonds! Although bond prices are inversely correlated to interest rates it does not necessarily mean that bond returns are inversely correlated to interest rates.
On this argument, it seems from a portfolio perspective, the case for bonds in the portfolio is much intact.
The media rhetoric seem to have confuse the long term investor.
Still if we are long from that perspective, total returns is what that matters.
And if we are looking at that, bond ETF provides a very easy way to gain exposure to these high quality fixed income.
The problem is that the expense ratio is 0.26% and tracking error is 0.19%. I am not sure if the 2.27% yield is net of these 2 fees (I suppose so)
We haven’t even consider the commission. The costs have taken out a lot of the returns possibly and it is likely that investors should do a lump sum yearly investment if their sum is not large enough to ensure low commission.
Still, the returns are better than cash currently, and in a rising interest rate environment, the bond ETF yields will go up and will make it more worthwhile.