Understanding Bond UCTIS ETF returns

Given the low interest rate environment in the Eurozone, how can I know the expected returns of a bond fund so I can compare it to other safe assets (e.g. a savings account) ?

I wrote before about the fact that the yields of Eurozone government bonds are low. Here, I want to explain how you can find information about the returns from a Bond UCTS ETF in order to compare it with other Fixed Income alternatives (e.g. savings accounts).

Introduction to Bonds

A bond is a loan to an entity (e.g. government, company)

With a bond you loan a certain amount of money (i.e. the principal), for a defined period of time (i.e. the maturity), for which you will earn a fixed yearly amount of money (i.e. the coupon).

For example, imagine you buy a hypothetical 10-year bond from the Portuguese Government with a principal of 1 000€ and a coupon of 20 €. That means that annually you would receive interest payments of 20€ (the coupon rate is 2% = 20/1000) for a period of 10 years. And at the end of the period you would receive your principal (1 000€) back.

coupon rate = coupon / principal

Pre-existing bonds can be resold in the open market. Bond prices may fluctuate to values other than the original (principal) amount (also known as face value) due to market demand, interest rate changes, political/economic instability, increase in likelihood of default of the borrower.

The bond’s yield determines the return on investment of the bond. It is equal to the coupon divided by the current value of the bond. If our (1 000 €) bond from the previous example would suddenly be worth 1 200 € then the yield would be 1.67% (20 € / 1 200 €) even though the coupon rate is 2% (20 € / 1 000€).

yield = coupon / price

Comparing the yield to the coupon rate allows you to understand if the bond is trading at a discount (prices decreased: yield > coupon rate) or trading at a premium (prices increased: yield < coupon rate).

Introduction to Bond Index Funds

A bond index fund is an investment fund whose underlying assets are bonds of different maturities and credit quality.

A bond index fund does not have a maturity date. It will keep buying and selling bonds in order to satisfy the requirements of the index. This means that the bond fund likely won’t be trading bonds at the face value but rather at the current market value which means the yield will be different than the coupon rate.

A bond index fund does not have a (fixed) coupon. A bond index fund will distribute dividends but they may fluctuate in value. Dividends will fluctuate because the yield of the underlying bonds fluctuates with market value.

A bond index fund does not have a concept of “getting your principal back”. A bond index fund is valued according to the market price of the underlying bonds. As a consequence, the value of your shares in the fund also fluctuate. This means that you may have a capital gain or a capital loss when you sell your shares.

Important yield metrics of a Bond UCITS ETF

As I wrote earlier, there are multiple Bond UCITS ETF metrics which are related to yield: Weighted Average Coupon, Distribution Yield, Weighted Yield To Maturity. Each metric gives a different perspective on the performance of the Bond Fund.

Weighted Average Coupon

The weighted average of the coupons of the underlying bonds. It is weighted because a bond fund holds multiple Bonds in different proportions. Remember that the a bond’s coupon rate is calculated based on the initial value (i.e. face value) of a bond. This metric does not contain information about the current market value of the underlying bonds.

Distribution Yield

Distribution yield is the total amount of dividends distributed in the last year divided by the fund’s current NAV (net asset value).
Remember that the distributed dividends fluctuate with the market price of the underlying bonds.
An accumulating ETF won’t have a distribution yield because it does not distribute dividends.

Weighted Average Yield To Maturity

The distribution yield and the weighted average coupon are metrics focused on the past. They don’t contain information about the current value of the bonds, and how changes in interest rates may affect returns. They don’t have any information about future expected returns.

The weighted yield to maturity (YTM) is the expected total return (of the underlying bonds) if you were to buy the bond ETF today and hold it until maturity. It is weighted to account for the fact that the bond ETF may hold different bonds.
This metric assumes all interests received are reinvested in the fund. This metric already takes into account any capital gains/losses you would get by selling the fund at maturity. The maturity of a bond ETF is the weighted average maturity.
The YTM isn’t static. It changes frequently as the outlook for interest rates and bond yields changes.

This is the best estimate of the returns you will get by investing in the bond ETF so you should pay special attention to this number. Note that it does not include fees, expenses, inflation.
To account for costs you may subtract the YTM by the Total Expense Ratio (TER). The tracking difference may also be considered a cost. The only issue of using tracking difference is that it changes frequently so you may need to average it out over multiple years.

The YTM is only a good indicator for expected total returns of non-hedged bond funds denominated in your currency (e.g. EUR). The total return of a non-hedged foreign bond fund will differ due to the impact of currency fluctuations. The total return of a hedged foreign bond fund will differ due to the impact of hedging.

YTM for EUR Hedged Bond Funds

Hedging has an impact on the total return of a foreign bond fund. The YTM is calculated using the local currency of the underlying bonds of a fund. Therefore, YTM is a poor metric to assess the future total return of a hedged foreign bond fund.

Vanguard Research has concluded that hedging, over the long-term, tends to make foreign bonds have similar returns to comparable domestic bonds. For example, hedging US Bonds into euros will give you yields comparable to German Bonds instead of US Bonds. The word similar is important, the returns may not be exactly the same but equivalent. It is a bit hard to define what a comparable bond is. Specially in regards to the Eurozone which is a currency block of countries with completely different economies and bond yields. German Bond yields are considered the “safest” bonds in the Eurozone and often used in comparisons as a result.

To conclude: the advantage of a hedged fund of foreign bonds comes from diversification and not from excess returns.

Where to find the yield metrics of a Bond UCITS ETF?

The important metrics of a Bond UCITS ETF can be found on the official website of the fund or on the Factsheet of the fund. justETF isn’t great for finding this information.

Some examples from the Bond funds I often mention below.

iShares Core Global Aggregate Bond UCITS ETF (EUR hedged, accumulating)

ISIN: IE00BDBRDM35

The website of the fund has the relevant information. Screenshot below.

Source: iShares

The fund’s Factsheet has additional information:

Source: iShares

Given this fund is hedged we can’t rely on its YTM to assess future returns from a Euros perspective. We need to find a comparable domestic bond fund and look at its YTM to understand that.

For those purposes I am using the iShares € Aggregate Bond UCITS ETF. This is a very rough comparison because the assets aren’t necessarily the same. But it is the best comparison I have. The yield metrics are below:

Source: iShares
Net YTM(Global Aggregate Bond fund) = YTM(Euro Aggregate Bond fund)  - TER(Global Aggregate Bond fund)
Net YTM = 0.25% - 0.10% = 0.15%
Net YTM(Euro Aggregate Bond fund) = YTM(Euro Aggregate Bond fund)  - TER(Euro Aggregate Bond fund)
Net YTM = 0.25% - 0.25% = 0%

I would use the Net YTM to compare the potential returns of a bond fund with a savings account.

Xtrackers Global Sovereign ETF (EUR Hedged)

ISIN: LU0690964092

The fund’s Factsheet has the relevant information. Xtrackers’ website isn’t as clear as iShares’ website.

source: Xtrackers

Given this fund is hedged we can’t rely on its YTM to assess future returns from a Euros perspective. We need to find a comparable domestic bond fund and look at its YTM to understand that.

For those purposes I am using the Xtrackers Eurozone Government Bond UCITS ETF 1C. This is a very rough comparison because the assets aren’t necessarily the same. But it is the best comparison I have. The yield metrics are below:

source: Xtrackers
Net YTM(Global Sovereign Bond fund) = YTM(Eurozone Government Bond fund)  - TER(Global Sovereign Bond fund)
Net YTM = 0.26% - 0.25% = 0.01%
Net YTM(Eurozone Government Bond fund) = YTM(Eurozone Government Bond fund)  - TER(Eurozone Government Bond fund)
Net YTM = 0.26% - 0.15% = 0.11%

I would use the Net YTM to compare the potential returns of a bond fund with a savings account.