Fixed-income funds and ETFs

As a rule, the higher the risk of an investment, the greater its potential return. This means, for example, that fixed-income ETFs usually generate lower long-term returns than equity ETFs. Bonds are considered low-risk and are generally used to stabilize a portfolio rather than generate high returns.

Of course, investors can still generate returns from their bonds. The size of these returns depends on several factors:

Maturity: Bonds with longer maturities generally yield higher returns than short-term bonds.

Credit: The credit rating indicates the ability of an issuer – for example, a company or a government – to meet its payment obligations in full and on time. A high credit rating means less risk – and therefore lower returns.

Central bank policy rates: In the eurozone, interest rates are often based on the key interest rates set by the European Central Bank. Countries outside the eurozone generally set their own key interest rates.

The return on bond ETFs is also influenced by other factors:

Bond index: Depending on the benchmark index, fixed-income ETFs invest in different securities, which in turn influence the fund’s risk profile.

Replication method: ETFs can replicate their indices in different ways, the most common methods being physical and synthetic replication (see below).

Costs and fees: Costs can reduce the fund return. Only after all costs and fees have been deducted can investors see how much of their return remains.

Essentially, all ETFs can be bought and sold on the stock exchange during regular trading hours, including bond ETFs. However, ETFs are particularly suitable as a medium- to long-term investment. Investors who sell their bonds due to short-term price falls often suffer a loss. Of course, they can also make a profit by selling their ETF shares when prices rise.

Bonds are usually suitable for a medium- to long-term investment horizon, whereas stocks are more suitable for long-term investments.

Not all ETFs are the same. Here is what you should bear in mind when selecting a fixed-income ETF:

- Replication method: ETFs can track an index in different ways, the two most common being physical and synthetic replication. With physical replication, the ETF invests in the actual securities that make up the index, resulting in a very accurate replication. With synthetic replication, on the other hand, the ETF replicates the index by investing in derivatives (usually a swap, often with a bank as counterparty).

- Dividend policy: When an ETF invests in bonds, these in turn generate interest, which the ETF can either distribute or reinvest. Distributing ETFs pay out interest to fund investors on a regular basis, for example annually, semi-annually or even monthly. By contrast, accumulating ETFs reinvest interest payments in new bonds, creating a compound interest effect. Which ETF is right for you depends on your preferences and goals. With distributing ETFs, you can generate passive income, whereas accumulating ETFs are primarily suitable for long-term wealth accumulation.

- Personal risk profile: How much risk you are willing or able to take depends on your personal risk profile and your investment objectives. Bond ETFs are considered a relatively stable investment, but they are not risk-free. The Vanguard Risk Indicator allows you to assess the risk of Vanguard bond ETFs quickly and easily.

- Costs and fees: Investing in an ETF incurs costs and fees, including the ETF provider’s management fees and transaction costs for buying or selling ETF shares. The higher the ETF costs, the lower the net return. This is why Vanguard ETFs are designed to be very cost-efficient – so that you can keep more of your returns. Further information on ETF costs can be found in the key information document (PRIIPs, KID) of the relevant ETF.

- Tracking Difference and Tracking Error: The tracking difference and tracking error indicate how accurately an ETF tracks its benchmark index, making them an important factor in selecting a fund. The lower the tracking difference, the more accurately the ETF tracks its index, and the lower the tracking error, the more consistent the tracking difference.

Which ETF is right for you depends on your goals and objectives. As bond ETFs are typically used to stabilize a portfolio, other factors such as risk, dividend policy, costs and returns also play a role. This means that you should ask yourself the following questions before making a decision:

– Which countries, regions, or companies would I like to invest in? For example, you can choose an ETF investing in Europe, the US, or worldwide.

- Do I want passive income? If you want to receive passive income from your investments, an ETF with monthly income distribution could be the right choice. If you would like to benefit from compound interest instead, you could opt for an accumulating ETF

– How much risk can I take (or do I want to take) with my fixed-income ETF?

Bonds play an important role in a diversified portfolio as they can reduce performance volatility while contributing to overall returns at the same time.

Fixed-income ETFs offer numerous advantages. As well as being highly diversified and easy to trade, their investment strategy and portfolio structure are both transparent. In addition, ETFs allow investors to participate in the performance of a vast number of fixed-income securities without having to buy each bond individually.

In essence, bond ETFs are a sensible choice for any investor profile as they often stabilize a portfolio, especially in turbulent market phases when stocks tend to be volatile. This quality makes them particularly suitable for investors seeking a balance between risk and return.

If you need help with your fund selection, please contact your financial adviser.