The VAF ETF invests in a basket of Australian bonds issued by the government (“treasuries”) and semi-government bodies (e.g. State Governments). The rest of the ETF is split across other types of issuers like financial companies (e.g. bonds issued by the big banks), foreign organisations issuing bonds in Australia and utility companies.
The resulting portfolio is mostly made up of very high-grade issuers (AAA, AA and A credit ratings).
VAF has fulfilled its purpose for the Rask ETF model portfolios, despite my initial concerns about interest rates. You can reference the performance of VAF in recent years with the ETF’s market price:
Back in early 2019, when I made VAF our chosen bond exposure for Rask’s model portfolios and the core exposure to a low volatility asset class, I had this to say:
Over the past thirty years, Australian interest rates, set by the RBA, have fallen considerably.
For the most part, falling interest rates have been a function of Australia’s economic liberalisation. For example, it was only in 1983 that the Government unpegged the Australian dollar and properly allowed our country to freely transact with global partners. In more recent times, growth (measured by inflation) has been slowing and the central bank has had no reason to push up interest rates.
In preparation of the launch of the Rask ETF strategy, one of my internal battles was trying to put my finger on a ‘normal’ level of interest rates to determine if now was the right time to buy into a bond ETF. For example, I asked:
- Will interest rates rise to over 3%?
- Will interest rates keep falling towards 0%?
- Should we use a cash ETF like AAA instead of a bond ETF like VAF?
- Is the low level of inflation in Australia the ‘new normal’?
I could find a seemingly endless number of reasons why interest rates might fall (and push up the price of the VAF ETF). On the other hand, I could find an endless number of reasons why interest rates might rise from here (and push down the price of the VAF ETF).
To be sure, I did not expect interest rates to fall to 0.25% today. If I were a betting man I probably would have said the opposite (and lost money). Fortunately, we don’t make bets on the market.
Swapping VAF for cash
Right now, the duration on most bond ETFs combined with the low — low — yield means investors could be paying a high price (i.e. taking more risk than they realise) just to have the comfort of bonds in their portfolio (i.e. an academic portfolio).
The effective duration of a bond ETF measures the portfolio’s sensitivity to interest rates.
For example, in theory, if a bond has a duration of 5 years, its price would fall by about 5% when interest rates rose 1%. On the other hand, the bond’s price would rise by about 5% when interest rates fell by 1%.
The RBA’s interest rate is currently 0.25%. Never say never but it may be difficult for interest rates to fall 1% from here.
Anecdotally, I know of many allocators who have been swapping their ‘core’ or long-term asset allocations of fixed income to tilt their portfolios to cash (e.g. term deposits), cash-plus ETFs or unlisted assets.
For us at Rask, I think it’s time we made a slow move away from allocations to bond ETFs like VAF. Meaning, since we are focused on ‘accumulating assets’ — rather than trading the core of our exposure to markets, we won’t be issuing a “sell” on our VAF exposure.
Rather, from here on out, when it comes to dollar-cost averaging and new contributions, we’ll be moving our model portfolios towards more unlisted cash assets (e.g. Government-backed term deposits — up to $250,000 per person per approved ADI) or enhanced cash ETFs.
For round figures in a hypothetical model portfolio, here’s the trade-off for investors considering swapping a bond ETF with a Cash ETF or term deposit:
|Product||Term deposit||Cash ETF (e.g. ISEC)||Bond ETF (e.g. VAF)|
|Effective duration||N/A||0.11 years||5.8 years|
When I look at the effective duration of a bond fund, the risk-reward skew does not seem reasonable to me. Remember, the effective duration of a bond ETF measures the portfolio’s sensitivity to interest rates. So, in a year or two from now, if interest rates rise, investors might have been better off in a term deposit.
If you’re looking to turn up the income/yield potential (and take more risk) you could explore a credit ETF, or even consider an active bond fund like the Betashares Active Australian Hybrids Fund ETF (ASX: HBRD), managed by Coolabah Capital. You can find out more about HBRD on the BetaShares website.
As with any decision, there are risks. For example, there are limits on the deposits per person per ADI under the Government deposit guarantee. Also, if interest rates fall again (it’s possible), a bond ETF might kick-in with some protection for an investor’s stock portfolio.
On the other side of the fence, keep in mind that Vanguard recently widened the sell spread on bond funds to be between 0.55% to 1.79% to exit a bond fund during the recent Coronavirus (COVID-19) volatility. Meaning, for investors who needed access to their ‘liquid’ capital, more than a year’s worth of yield could have been consumed to exit the fund. Imagine if you lost a year’s worth of a dividend…
If we look at the merits of having more capital in term deposits or cash, investors are adding the optionality of having liquid capital and, if they shop around for the best term deposit, there could be a meaningful kicker from the interest rates. For example, right now, anyone can get a term deposit at a big bank yielding at or around 1%.
Having capital in one of the most liquid asset classes means investors are also ready to pounce on new opportunities in shares, credit or unlisted asset classes when the time arises. Of course, read the PDS of the term deposit (and know the fees) before investing.
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Disclosure: at the time of publishing Owen does not have a financial interest in any of the ETFs or companies mentioned.