How do Exchange Traded Bonds work?

4 mins read

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Getting access to corporate bonds through the Australian Securities Exchange (ASX) provides investors with an affordable way to improve balance in their portfolio while allowing them to buy and sell with the transparency of any other security.

Exchange traded bonds (XTBs) combine the predictable income and capital stability of corporate bonds with the transparency and liquidity of the ASX, according to Australian Corporate Bond Company Co-Founder and CEO, Richard Murphy.

They’re safer than equities but have greater yields than a term deposit, he says but adds, “you don't buy an XTB expecting it to double in price.”

XTBs were introduced to the ASX in 2015, giving retail investors access to an asset class they'd been largely priced out of.

While wholesale bonds are usually bought in minimum $500,000 parcels, investors buying XTBs are purchasing units in a trust that has exposure to a single corporate bond.

“XTBs give all the economic characteristics of a bond, without you actually owning the bond. The bond is sitting in the listed trust that issued the XTB,” says Murphy.

You know what you’re getting

Bonds offer investors a known income stream and a known outcome at maturity.

“They're very, very low volatility,” says Murphy. “Shares have had around 15 per cent annualised volatility since 2000. Hybrids have about 7 per cent annualised volatility over the same period.”

“If you look at corporate bonds and XTBs, fixed-rate bonds have had 2 per cent annualised volatility and floating-rate bonds, 0.2 per cent.”

XTBs make periodic interest payments to the owner. The coupon rate can be fixed or floating but, regardless, it's generally more attractive than a term deposit yield.

“By a country mile the number one investor we have is people with money in term deposits where they're only earning 2-point-something percent but they want maybe 3-4 per cent,” says Murphy.

Another distinction is that with XTBs, the full face value of the investment is returned in cash when the bond matures.

“That is a very, very critical distinction from managed funds, ETFs and hybrids where you never get your money back and you can't predict what you're going to earn,” says Murphy.

“With XTBs, you know on the day you invest what your coupon is going to be in November 2017 for example, November 2018, and November 2019. And you know when you'll get your principle back.”

What are the risks?

The number one risk associated with XTBs is credit risk, says Murphy.

“The only thing that will throw out your return is the company going into default. You need to think 'am I investing in companies that are a low risk of collapsing',” he says.

With XTBs currently only offered for companies in the ASX Top 100, Murphy says that lending your money to Woolworths, Lendlease and Telstra individually (by buying XTBs) rather than lending it to a bank in a term deposit, is “basically a little bit more risk for a bit more return”.

The second major risk is interest rate hikes: interest rates and bond prices have an inverse relationship so when one goes up, the other goes down.

That's a problem if you have to sell your XTB before it matures. For example, say interest rates go up 1 per cent, the value of your three year bond would drop around 0.7 per cent.

But Murphy says that, other than simply buying and holding, there are ways to reduce interest rate risk, including investing in floating rate bonds.

“Their coupons go up when interest rates go up so they're not impacted at all by interest rate changes,” he explains.

XTBs may be suitable for those:

  • looking to boost the defensive part of their investment portfolio
  • wanting capital stability and fixed income, particularly SMSF investors and retirees
  • who want a better yield than term deposits offer

Ask your financial adviser about how bonds might work in your portfolio.

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Important: This article has been prepared without taking account of the objectives, financial or taxation situation or needs of any particular individual. Before acting on the information, you should consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice. Any information used in this article is for illustrative purposes only. Australian Corporate Bond Company is an external entity that is not a member of the Commonwealth Bank of Australia Group of Companies (the Group) and the content or any view expressed by Australian Corporate Bond Company and its employees does not represent an endorsement, recommendation, guarantee or advice in regard to any matter. CBA, nor members of the Group accept any liability for losses or damage arising from any reliance on external parties their products, services and material.