ETF: Bonds in your ETF portfolio

Kristia van HeerdenETF Blog, Latest

Danish fund manager and author Lars Kroijer advocates for a simplified do-it-yourself investment strategy comprising of two simple investments. The first is an ETF with global exposure. The second is bonds with a time horizon similar to our investment horizon.

For the ETF, the Ashburton 1200 caught our attention because it offers a small amount of exposure to emerging markets. The CoreShares Global Dividend Aristocrats ETF offers very similar exposures, although weighted differently. Those who feel their South African investments offer enough emerging market exposure can choose from a growing variety of global ETFs.  

The bond part of the equation is more complicated. At what point should you start adding bonds to your portfolio? Kroijer advices holding bonds with a maturity date similar to your investment horizon. Is that still true for an investment horizon of 20 years or more? Also, what percentage of your portfolio should be in bonds? Should you hold an equal amount of bonds and ETFs? Which bonds should you get? On the South African market alone, one has access to global bonds (the 1nvest Global Government Bond ETF, Ashburton World Government Bond ETF and Satrix Global Aggregate Bond ETF), US Treasury Bills, South African government bonds, Namibian government bonds and inflation-linked bonds. Outside of the stock market, South Africans have access to retail government bonds with truly excellent global rates.

Where you choose to invest your bond money will have a significant impact on the stability of your portfolio. As the COVID crisis showed us, during a crisis the secondary bond market responds pretty much like the equity market. If you opt for a bond ETF instead of retail government bonds, your portfolio is subject to supply and demand in the bond market, just like shares. The inverse correlation between price and yield makes your returns on a bond ETF far less predictable.

Remember that the returns you earn on your bonds is linked to the interest rate environment. The impact of that becomes glaringly obvious when one considers the prevailing rates on US Treasury Bills. At fractions of a percent, holding a product like the DCCUSD is more of a currency play than an investment.

Deciding on the right combination of bonds to equities at the right time is difficult. Presumably a longer time horizon means investors can afford less bond exposure overall and possibly more emerging market bond exposure. Once one becomes dependent on income from investments, deciding between a local bond offering and an international one becomes worthy of consideration.

Lastly, don’t forget that income from bonds is taxed at your marginal rate after your exemption applies. If you are already earning a huge amount of interest income, bond coupons could result in inefficient tax liability. That said, if you sell your bond ETF at a profit, you will have to declare a capital gains event. This might result in double-taxation: tax on income and tax on capital gains.

The right asset allocation is always tricky – even when you only have to choose between two types of assets. Hopefully considering your investment  horizon, your tax liability and your risk appetite will help you choose when you should start thinking about adding bonds to your portfolio.

ETF blog

ETF blog logoAt Just One Lap, we are big fans of passive investment using ETFs. In this weekly blog, we discuss ETFs on the local market and the factors you need to consider when choosing an ETF. If you have wondered how one ETF differs from another, this is where you can find out. We explain which index each ETF tracks, what type of portfolio could benefit from holding each ETF, and how the costs will affect your bottom line.