ETF Report UK: Why I Own Corporate Bonds

February 03, 2015 sits down with Edward Allen, investment director of Ingenious Asset Management, to talk about his use of the iShares £ Corporate Bond 1-5 Year UCITS ETF (IS15).

This article comes from our quarterly magazine, ETF Report UK, for financial planners. To read the full magazine click here

When did you start using the IS15?

I first bought this ETF in February 2013.

Why did you choose IS15?

We used IS15 as a partial solution to the conundrum of the last few years, which is how to generate above cash returns with low risk of capital loss. The iShares £ Corporate Bond 1-5yr UCITS ETF provides a diversified exposure to Sterling denominated investment grade bonds, incorporating 233 underlying holdings. It has a yield to maturity [as of 30 September, 2014] of 2.78 percent, a modified duration of 2.6 years and costs just 0.20 percent per annum.

It is, however, only a partial solution, as risks remain, both in interest rates and in credit. In addition, given that the fund is forced to sell each issuance at a one year maturity, you never have the comfort of being able to hold a bond to maturity.

What are the attractions of IS15?

The attractions lie in convenience, cost and simplicity. 
First, convenience: It would be difficult, even for a large portfolio, to build a portfolio of short dated corporate bonds to diversify credit risk as effectively as done by this ETF. The largest holding is Barclays Bank at just 2.4 percent of the portfolio. In a small portfolio this would be an impossibility, but I can gain exposure in small size within this ETF.

Next, cost: There will be times when active bond managers outperform, but in a space where the volatility of outperformance is likely to be small, cost plays an essential role. By using an ETF, we save between 0.30 and 0.80 percent per annum on equivalent actively managed funds.

Finally, simplicity: It's easy to characterise and to understand its role.

How do you use IS15?

With its low yield and duration, this asset class sits just above cash in risk terms, and below longer duration bonds. Given that I'm relatively comfortable with the credit risk, it therefore forms the lower risk end of the fixed income part of a portfolio. As such, it should, if successful, be dull, throwing off an above cash yield and maintaining a relatively steady NAV per share.

Do you find that IS15 is weighted too heavily in any particular area?

The ETF has a very heavy weighting in financials, with banks, insurance companies and diversified financial services making up just over 50 percent of the fund [source: Bloomberg]. The reappearance of systemic banking risk would therefore be a poor scenario for this fund, in that in such an environment, bank credit risk would come back into question. The risk with any non-cash but low risk security is that you have the ever-present risk of loss with limited upside! However, in most scenarios [including the current falls], this should be a relatively defensive fund.

It's also interesting to note that just over 50 percent of the issuers lie outside of the United Kingdom; this is a sterling-denominated ETF, and not one exclusively focused on the UK. The next largest single country of origin, as one might expect, is the US at 15 percent, but it's important to note that issuers based in European countries make up around 30 percent of the fund [source: iShares]. So whilst there is no currency risk within the fund's constituents, this certainly exists within the bond issuers' underlying earnings.

What else would you use to replace IS15?

Short of creating a portfolio of short term corporate bonds, any replacement would have to either increase, or decrease risk. For example, credit risk might be increased by moving to high yield corporates, or decreased by moving to gilts. Duration could be extended by buying a longer dated fund such as SLXX or decreased by going to cash.

In conclusion, this fund captures an important, if (hopefully) dull, part of the fixed income landscape. It has historically provided an increment to cash returns but, as ever, investors should be aware of the underlying risks.


Find your next ETF

Reset All