Why bond ETF distributions bounce around

A question that is often asked about bond ETFs, is why their distributions bounce around. The question is a good one, given that bonds by their very nature are designed to provide a steady flow of interest payments.

To explain the reasons why, we’ll look at two bond ETFs. The first is IAF, which is Blackrock’s iShares Core Composite Bond ETF, and the second is VBND, Vanguard Global Aggregate Bond Index (Hedged) ETF.

Surprisingly, the bouncing around in the distributions of each of these ETFs has occurred for different reasons.

IAF

IAF is a diversified portfolio of 537 different bond holdings, all with different coupon interest rates and maturity dates. The ETF contains Australian Government Bonds (52.9%), state Government related bonds (38.0%), corporate bonds (8.1%) and 1% of cash.

Here is IAF’s distributions to shareholders over the past 8 quarters.

As can be seen, there is a reasonable amount of variance from quarter to quarter, so what is happening?

As IAF tracks an index (the Bloomberg AusBond Composite 0 Yr Index), it needs to keep in step with that index. As the index changes (to stay representative of the Australian bond market), so to, IAF must also change and adjust its holdings. This may result in realised capital gains or losses.

A spokesperson from Blackrock explained it this way, “The variance in distributions from quarter to quarter is due to realised net losses/gains on the sale of securities. As this fund rebalances monthly, the fund could experience higher turnover while there is higher volatility in the market”.

As to why the distributions are not smoothed out, the Blackrock spokesperson said, “iShares does not have a policy to smooth distributions from this ETF. Under local tax regulations and accounting standards, income for distributions from an attributed managed investment trust can vary from the coupons received from the held investments. At the end of the tax year, all distributable income is attributed to investors in their tax statement”.

VBND

Another bond ETF that has also experienced an unusual run of distributions is VBND, the Vanguard Global Aggregate Bond Index (Hedged) ETF. This ETF seeks to track the Bloomberg Global Aggregate Float-Adjusted and Scaled Index, hedged into Australian dollars before taking into account fees, expenses and tax.

Here are VBND’s quarterly distributions to shareholders during 2020 and 2021.

As can be seen from the table, the distribution for the Sep 2020, Dec 2020 and March 2021 quarters were extraordinarily high. So, what happened?

We reached out to a Vanguard spokesperson who explained, “Many funds whether equity or fixed income offer both hedged and unhedged versions, to provide investors with the choice of tailoring their portfolio with currency hedging decisions that align to their objectives based on their risk appetite. Hedging can be applied to international bonds (fixed income), and it's generally accepted that in order to maintain the low-risk defensive characteristics of bonds in a portfolio that they should be hedged. All of Vanguard’s fixed income funds are currency hedged”.

So, with hedging in place, when the Australia dollar rises, as it did during 2020 and early 2021, profits are generated.

The Vanguard spokesperson said, “VBND is currency hedged to the Australian dollar, which means the value of the underlying bonds is not affected by movements in the Australian dollar. To do this, the underlying funds invest in forward foreign exchange contracts. When the Australian dollar rises against the major currencies, a profit is generated. According to the ATO, these profits are to be treated as income. During this period, the Australian dollar saw strong increases against major international currencies such as the US Dollar and Euro, which this fund has considerable exposure to (nearly 80% of the fund is exposed to North America and the Eurozone). This led to a higher level of income being earned by the fund during this period which in turn was distributed out to investors”.

In Summary

Though the distributions may bounce around a little, bond ETFs are always an important part of a balanced portfolio, and as such, both IAF and VBND are found in many of InvestSMART’s diversified ETF Investment Portfolios.

Bond ETFs provide the important qualities of a constant stream of regular distributions, preservation of capital, and asset class diversification.