An introduction to bond ETFs

A bond is a debt certificate of a loan issued by a company or a government agency.  Investors lend out money for a specified time period and interest rate, also called a “coupon”. 

When creating your financial plan you are going to create an asset allocation based on your risk profile, an appropriate mix of riskier assets and lower-risk assets.  Riskier assets are, for example, stocks or real estate.  Lower-risk assets are, for example, cash, short-term bonds or medium-term bonds.  

Important role in your overall portfolio

The role of bonds in your overall portfolio should not be underestimated.

Bonds provide more diversification in your portfolio, i.e. you spread the risk between stocks and bonds.  This diversification is most obvious with government bonds.  Because of their low volatility, bonds fluctuate less than stocks. 

In a stock market crash, the bond portion of your portfolio ensures losses are limited.  

To estimate the possible loss in a stock market crash, we can look at figures from the past : the Bogleheads calculated the cumulative return after inflation in the 2000-2002 bear market ⁽¹⁾. 

A portfolio of 80% stocks and 20% bonds lost about 35% in these 2 years and a portfolio of 50% stocks and 50% bonds only lost about 14%. We also learn from the past that risky assets can yield more in the long term than lower-risk assets.

In your financial plan, you have established an asset allocation (stock/bond distribution).  During or after a bear market (stocks show a downward trend) or a bull market (stocks show an upward trend) this asset allocation gets out of balance.  You can solve this by rebalancing. 

Suppose you have established an asset allocation of 80% stocks and 20% bonds in your financial plan.

• After a decline in the stock markets, this asset allocation became 60% stocks and 40% bonds.  To bring your asset allocation back in balance, you rebalance by selling part of your bond ETFs and  buy equity ETFs for the same amount.  After rebalancing, your asset allocation will again be 80% equities and 20% bonds as defined in your financial plan.
• After stock markets rose, this asset allocation became 90% stocks and 10% bonds. To bring your asset allocation back in balance, you will rebalance by selling part of your equity ETFs and buy bond ETFs for the same amount.  After rebalancing, your asset allocation will again be 80% equities and 20% bonds, as defined in your financial plan.

Timing for rebalancing is a personal choice.  You can rebalance at a fixed time, for instance once a year, and your birthday is a common choice.  You can also rebalance if your shares or bonds deviate a certain percentage from the asset allocation determined in your financial plan.

Selection criteria for bond ETFs

We use ETFs for passive investing in Belgium.  An ETF (Exchange Traded Fund) is an investment fund which is (usually) based on an index. The provider of an ETF, such as Vanguard and Blackrock, buys and sells shares/bonds based on their weight in the index. The big advantage of an ETF are the management costs.  The manager can keep these costs very low because there is almost no manual work involved, unlike actively managed funds.

You can trade ETFs on the stock exchange.

I select my bond ETFs based on the following criteria (disclaimer :  primarily for Belgian investors) :

1. Quality: the quality depends on the issuer, e.g. governments or companies, and associated creditworthiness.  There are 3 rating agencies that determine the creditworthiness: Moody’s, S&P and Fitch.  I focus on safer bonds, also called investment grade bonds.  Investment grade bonds with the best quality are rated “AAA” (S&P / Fitch) or “Aaa” (Moody’s). The lower limit for investment-grade bonds is “BBB-” (S&P / Fitch) or “Baa3” (Moody’s) ⁽²⁾.  Government bonds are usually safer than corporate bonds.
2. Maturity : each bond can have a different maturity.  Some have a short maturity (less than 5 years), others have a medium maturity (between 5 years and 10 years) or a long maturity (more than 10 years).  Generally speaking, the longer the maturity, the higher the coupon. But … the value of bonds, and therefore bond ETFs, change with changing interest rates.  If the (market) interest rate rises, the values of the current bonds fall, it is at that moment more interesting to invest in new bonds with higher interest rates than the current bonds.  If (market) interest rates fall, the values of current bonds rise, at that moment these are more interesting than new bonds.  In addition, a long(er) maturity creates a kind of ‘multiplier’ effect.  A bond with longer duration is more volatile than a bond with short duration.  Why? A change in interest rates has a much greater impact on long(er) duration bonds than short(er) duration bonds. To cut a long story short: you should select bond ETFs with a short or medium duration, i.e. maximum 10 years.
3. Diversification : the main reason for this is spreading the risks.  If you invest in 1 bond and the issuer cannot meet the payment conditions, you lose the full value of your bond investment.  If you invest in a bond ETF containing hundreds of different bonds and one issuer cannot meet the payment terms, you do not lose the full value of your bond investment.  
4. Full replication : the provider of an ETF with physical replication purchases bonds that are part of the index.  A first advantage is transparency, you know perfectly what’s in the ETF.  Another advantage is security : the ETF provider effectively owns the bonds and these are the collateral if the provider goes bankrupt.  
5. Expense Ratio : the provider of an ETF charges shareholders an expense rate to cover the operational costs of the fund.  Here, I’m aiming for a maximum annual percentage rate of charge, also called Total Expense Ratio (TER), of up to 0,50%.
6. Accumulating : in Belgium we pay 30% withholding tax on coupons. An accumulating ETF reinvests the coupons, and therefore you don’t have to pay this withholding tax.
7. Domiciled in Ireland : Ireland does not tax foreign investors on dividends and coupons.   
8. Issued in Euro : you buy or sell the ETF in Euro and thus avoid exchange rate costs.
9. Currency of bond : bonds in foreign currencies (non-Euro currencies) expose you to a currency risk.  This risk can influence your return if your ETF contains a lot of bonds with foreign currencies and the exchange rate with the Euro penalizes you.  There are two possible solutions: 1) invest in European bonds without currency risk, or 2) hedge against this currency risk.  The TER of hedged bond ETFs is a little bit higher than the TER of the non-hedged version.
10. UCITS : The ETF complies with EU regulations to protect the public from unsuitable investment vehicles.
11. Fund size : ETFs are only profitable when they have a certain size, if they are not profitable the fund may close its doors.  Smaller ETFs typically have a lower trading volume and are therefore generally less liquid.  With a fund size of about 100 million, an ETF can be managed cost-effectively ⁽³⁾.
12. Not registered in Belgium : Belgians pay a lower tax on stock exchange transactions (TOB) for each purchase and sale of funds that are not registered in Belgium but are registered in a country of the European Union.  

Some examples of ETFs that meet these criteria

VGEA : Vanguard EUR Eurozone Government Bond ⁽⁴⁾

This ETF is described as follows : “The Bloomberg Barclays Euro Aggregate Treasury index tracks Euro denominated government bonds issued by members of the eurozone. All maturities are included. Rating: Investment Grade.”

This fund invests in European government bonds with an average credit rating of ‘A+’ ⁽²⁾. Replication is physical and the total expense ratio is 0,07%.

The distribution policy is accumulating, coupons are reinvested in the fund.  The domicile of the fund is Ireland and the ETF is issued in Euro.

This fund complies with UCITS regulation.  The fund size is over 500 million and this is certainly large enough to be profitable and liquid.  This fund is not registered in Belgium.

AGGH : iShares Core Global Aggregate Bond (hedged) ⁽⁵⁾

This ETF is described as follows : “The Bloomberg Barclays Global Aggregate Bond (EUR Hedged) index tracks bonds issued in emerging and developed markets worldwide. Rating: Investment Grade. Currency hedged to Euro (EUR).”

This fund invests in global government bonds (55%) and corporate bonds (45%) with an average estimated credit rating of ‘AA-‘ ⁽²⁾. Replication is physical, and the total expense ratio is 0,10%.

The distribution policy is accumulating, coupons are reinvested in the fund.  The domicile of the fund is Ireland and the ETF is issued in Euro.  The underlying bonds are issued in USD, but are hedged into Euros.

This fund complies with UCITS regulation.  The fund size is over 1 billion and this is certainly large enough to be profitable and liquid.  This fund is not registered in Belgium.

VDTE : Vanguard USD Treasury Bond (hedged) ⁽⁶⁾

This ETF is described as follows : “The Bloomberg Barclays Global Aggregate US Treasury Float Adjusted (EUR Hedged) index tracks US sovereign debt, issued by the US government. ‘Float adjusted’ means, the index does not consider bonds that are unavailable to the public. Currency hedged to Euro (EUR).”

This fund invests in U.S. government bonds with an average credit rating of ‘AAA’ ⁽²⁾.  Replication is physical, and the total expense ratio is 0,12%.

The distribution policy is accumulating, coupons are reinvested in the fund.  The domicile of the fund is Ireland and the ETF is issued in Euro. The underlying bonds are issued in USD, but are hedged into Euros.

This fund complies with UCITS regulation. The fund size is over 50 million, so in principle not big enough to be profitable, but this fund only exists for less than a year.  This fund is not registered in Belgium.

Another word on taxes…

Some investors are skeptical about bonds in general, in Belgium we pay a tax of 30% on the capital gains of bonds.  

The main reason for including bonds in your portfolio is stability, to absorb downward shocks from the stock market.  Generating income through bonds is therefore not the main reason.

It is recommended to only sell bonds when rebalancing.  Here you only sell a (small) part of your bonds, and you only pay taxes if there are capital gains on these bonds.

Which bond ETFs do you own and why?   Let us know in the comments!

This info is for informational, educational and entertainment purposes only, and does not constitute financial, accounting, or legal advice. Please do your own research (disclaimer).

Sources :

(1) Bogleheads. (2019, November 29). Asset allocation – Bogleheads. www.bogleheads.org. https://www.bogleheads.org/wiki/Asset_allocation 

(2) Wikipedia. (2021, May 24). Bond credit rating. Wikipedia. https://en.wikipedia.org/wiki/Bond_credit_rating 

(3) JustETF. (2021, March 17). Size matters when it comes to ETFs. https://www.justetf.com/uk/news/etf/size-matters-when-it-comes-to-etfs.html 

(4) JustETF. (n.d.). Vanguard EUR Eurozone Government Bond UCITS ETF Accumulating | A2PA8D | IE00BH04GL39. www.justetf.com. https://www.justetf.com/en/etf-profile.html?query=IE00BH04GL39&groupField=index&from=search&isin=IE00BH04GL39 

(5) JustETF. (n.d.). iShares Core Global Aggregate Bond UCITS ETF EUR Hedged (Acc) | A2H6ZT | IE00BDBRDM35. www.justetf.com. https://www.justetf.com/en/etf-profile.html?query=IE00BDBRDM35&groupField=index&from=search&isin=IE00BDBRDM35 

(6) JustETF. (n.d.). Vanguard USD Treasury Bond UCITS ETF EUR Hedged Accumulating | A2P741 | IE00BMX0B631. www.justetf.com. https://www.justetf.com/en/etf-profile.html?query=IE00BMX0B631&groupField=index&from=search&isin=IE00BMX0B631