Interest rates are on everyone’s mind at the moment as cost of living pressures increase and the RBA clamps down on spending. Could the iShares Core Composite Bond ETF (ASX: IAF) be a smart investment?
What are bonds?
First of all, what are bonds and why would you consider adding them to your portfolio?
Bonds represent debt. In the simplest terms, a lender gives money to a borrower which creates a bond. The borrower pays interest payments and when the loan expires (reaches maturity) they pay back the original amount borrowed.
In the investment world we normally talk about government and corporate bonds. The government (or more precisely the Reserve Bank of Australia) will occasionally issue bonds to institutional and retail investors. It goes a bit like this.
Let’s say the RBA issues a $100 bond with a 3% interest rate and a 5-year term. You buy that bond for $100 (it could be for more or less but for simplicity we’ll say it’s $100). For the next 5 years the RBA will pay you an interest rate of 3% of $100 per year in quarterly or twice-yearly distributions. At maturity (the end of the 5 years) they pay you back the $100.
When you break it down to a simple example like that the benefits become clear. As an investor, you get security (you know you’ll get your $100 back) and you get guaranteed interest payments of 3% for the next 5 years. Bonds are classed as defensive assets because they hold their value for the initial purchaser.
Adding bonds to your portfolio can add diversification, bring down the overall risk of your portfolio, and provide regular income.
What’s this got to do with interest rates?
In the example above we looked at an investor buying the bond when it was issued and holding it until maturity. This can be done, but in reality bonds are often bought and sold during the term in what’s called the secondary market.
The bond was originally worth $100 (this is called the face value) but over the 5 years it could be sold for more or less than $100. Crucially, the interest payment is always calculated on the face value, so in this case it always stays at $3.
So, why would you pay more than $100 for something that’s only going to pay you back $100 at maturity?
It’s all about the interest rate.
Right now if a bond is paying 3% interest, that’s not very attractive when the RBA cash rate is 4.35% and many banks are offering savings accounts with interest rate of 4.5% or more. The bond is not worth much.
However, let’s imagine the RBA cuts the cash rate to 2% (mortgage holders rejoice!). Suddenly, banks are paying 2-2.5% interest on your savings account and the 3% interest rate on the bond looks great. So, when interest rates fall, bond prices on the secondary market increase.
Let’s say that same bond has 3 years left until maturity and the RBA cash rate falls to 2%. If the bond price moves from $100 to $102, you could buy it at $102 and still get $3 per year (a 2.94% interest rate) which is still better than what you’d get from a bank account.
The further interest rates fall, the more bond prices will normally increase.
The IAF Bond ETF
The RBA cash rate is currently at 4.35% which is the highest it’s been since 2011. While inflation is proving to be persistent it stands to reason that at some point the economy will slow enough that the RBA will look to start cutting rates again. I wouldn’t expect it to get back to the historical lows we saw in 2020 but it will likely drop.
Certainly, most economists are saying a cut in 2025 is much more likely than another increase.
So, now might actually be a reasonable time to consider bonds.
The iShares Core Composite Bond ETF (ASX: IAF) is an exchange traded fund listed on the ASX that invests in Australian government and corporate bonds. It forms part of the Rask Invest funds because of the benefits it brings as a defensive and income-focused asset.
While the historical return has been low (around 2% per year over the last 10 years) you can clearly see by looking at calendar year returns how it’s affected by interest rates. The IAF ETF returned 7.09% in 2019 when the RBA made 3 cuts and returned 4.33% in 2020. In 2022, when rates were rapidly rising, IAF lost 9.88%.
You may not normally consider bonds because of the seemingly low returns but it’s important to remember that they provide diversification, capital protection, and income benefits. And, if you’re savvy about when you choose to increase your exposure they can be a source of capital growth too.
To understand more about the IAF ETF and the role it plays in the Rask Invest funds, you can book a free call here with our Head of Funds Management Mitch Sneddon.
