Are government bond ASX ETFs still a good option in Australia’s low-interest-rate environment?
ETFs are managed funds that are listed on a securities exchange, such as the ASX. They can be active managed funds or index funds. In other words, active or passive. ETF fees are usually lower than unlisted managed funds.
Typically, ETFs give an investor exposure to many different shares or assets with a single purchase, offering one of the quickest and easiest methods of achieving diversification. Our complete list of ASX ETFs provides the names of all ASX ETFs.
Why Government Bonds?
There are plenty of Australian government bond ETFs to buy on the ASX, including the BetaShares Australian Government Bond ETF (ASX: AGVT), the Vanguard Australian Government Bond Index ETF (ASX: VGB) or the iShares Treasury ETF (ASX: IGB). But why government bonds?
Australian Commonwealth government bonds provide several benefits to investors. The first benefit is a high credit rating. Australian government bonds have a AAA credit rating -– the best you can get –- meaning the risk of default is deemed to be very low.
You won’t find this sort of security when you’re investing in corporate bonds or even government bonds in a lot of other countries. With this high credit rating comes a lower coupon/income rate than what you would receive from other bonds. You’re taking on less risk, so you’re going to end up with a lower return.
However, government bonds still provide regular income that can be attractive when you look at it from a risk versus reward perspective.
Government bonds also provide diversification because their returns tend to be negatively correlated to equities, meaning when the share market falls, bonds tend to increase in value.
How About The Diversification?
To understand why government bonds may no longer be an attractive investment, it’s important to understand why they are usually negatively correlated to equities.
Government bonds don’t just rise in value because the share market falls. It’s all to do with interest rates. When the Reserve Bank of Australia (RBA) cuts interest rates, the value of bonds increases because of an opportunity cost. The bonds you hold now appear more attractive because the coupon rate on offer is superior to what you could get investing in new bond issues.
This is why bonds tend to perform well when equities are falling. These are usually times in which interest rates are cut and investors reallocate towards bonds for the security they offer.
The BetaShares ETF mentioned above, AGVT, tracks an index called the Solactive Australian Government 7-12 Year AUD TR Index.
This index vastly outperformed the S&P/ASX 200 (INDEXASX: XJO) between February and December 2008, January to December 2011 and February 2015 to February 2016.
The similarity between all three of these time periods is interest rate cuts, the largest of which came between February and December 2008 when interest rates were cut from 7% to 4.25%. In the following two time periods, interest rates were cut again but by smaller amounts, and government bonds outperformed again but also by smaller amounts.
In other words, the outperformance of government bonds is dependent on how many times interest rates are cut.
Our New Low-Interest Rate Environment
With today’s cash rate at just 1%, it’s questionable whether these events can repeat themselves any time soon. Assuming the RBA won’t introduce negative rates, which is not impossible, they only have 1% to work with and cutting by 2.75% like they did in 2008 is not an option.
With rates already so low, I believe it’s unlikely that government bonds will perform as they have in the past because the factor that fuels their appreciation is quickly running out.
While I can appreciate the benefits of a small allocation to government bonds, I don’t believe it makes sense to allocate any large portion of a portfolio to this asset class right now when meaningful appreciation looks unlikely and the yield is so low.
Disclosure: At the time of writing, Max does not own shares in any of the companies mentioned.