Investment: Passive income with bonds: With these ETFs you earn interest eight times a year

With term funds based on corporate bonds, investors can put together a portfolio that brings in regular income. Exchange rate fluctuations hardly play a role.

Frankfurt. Putting money to work to easily generate additional monthly income is possible with bonds. Unlike stocks or gold, investors with bonds can ignore interim price fluctuations.

The reason: Bonds have a fixed term, at the end of which they are repaid if the debtor remains solvent. Concerns about inflation, interest rate hikes by central banks and rising national debt have caused bond prices to fall significantly in recent months.

Therefore, the returns have increased significantly in return. This applies above all to government bonds, but also to corporate bonds. Many strategists consider this to be interesting because, unlike states, many companies reduce their debt.

In order to keep the risks as low as possible, it is advisable to invest in broadly diversified funds. According to experts such as Olaf Stotz, Professor of Asset Management at the Private University Frankfurt School, conventional bond funds without a maturity date are not very suitable for passive income. The reason for this is that the prices of the funds fluctuate with the prices of the bonds. This makes the system difficult to calculate.

Bond funds with a fixed term are better suited. They have also been available as inexpensive exchange-traded funds (ETFs) for almost three years.

The Handelsblatt explains what investors should pay attention to when it comes to ETFs on corporate bonds and shows which fund combinations will get you interest on your account every quarter.

Term funds for bonds work in a similar way to the bonds themselves. Investors invest a sum, receive interest and their money back at the end of the term. The prices of term funds also fluctuate. However, investors can ignore this if they hold the funds until maturity. The aim is for the funds to be repaid at the issue price. Most of these ETFs are offered by the providers iShares from Blackrock and Xtrackers from DWS.

Maturity funds can be recognized by the name “iBonds” at iShares and by the name “Target Maturity” at Xtrackers. The distributing variants of “iBonds” transfer interest in March, June, September and December. The Target Maturity ETFs do this in February, May, August and November. With a combination of these funds, investors receive money transferred eight times a year.

The ETFs denominated in euros are available with terms of two and a half to a good ten years. The providers have created corresponding bond indices for this purpose. They include bonds from companies, banks and insurers with good creditworthiness and take sustainable criteria into account.

The bonds in the ETFs mature roughly when the ETFs are liquidated and investors get their money back. Most of the bonds in the ETFs expire before the ETFs. The money from the bonds repaid before the fund deadline is invested in short-term government bonds.

This and the fact that new bonds are included in the ETFs during the monthly reviews if they fit the index have two consequences: Firstly, the number of bonds changes. Short- and medium-term ETFs invest in around 300 to 400 bonds. There are significantly fewer ETFs that don't expire for another nine or ten years. Over time, however, there are more and more bonds that fit into the index and are included.

The dynamics of the portfolios make the interest payments and returns on term ETFs more difficult to calculate than investments in an individual bond. For bonds, yields are the annual return that investors receive if they hold the bonds to maturity. They essentially result from the interaction of interest payments and the difference between the purchase price and the repayment price of 100 percent.

However, David Wenicker, who is responsible for business with sales partners for private customers at BlackRock in Germany, is convinced that iBonds “offer predictable cash flows with broad portfolio diversification.” The providers indicate the approximate returns investors can expect for the individual term ETFs.

The central thing about bonds is that the returns are more important than the interest paid out. The interest or interest coupons on the bonds are fixed when they are issued and do not change. They always refer to the repayment value of 100 percent.

Bonds are traded during the term. This causes the prices to change. When they fall, yields rise because the fixed interest payments are higher in percentage terms compared to a lower purchase price than compared to a high purchase price. Conversely, returns decrease when prices rise.

The longer the term of the bonds, the more the bond prices fluctuate. The reasons for this are that longer-term bonds have more interest payments outstanding and investors take greater risks with regard to economic developments, inflation and changes in central bank interest rates.

As a result, the returns on long-term bonds are generally higher than those on short-term bonds. This is also evident in term ETFs. From a current perspective, the expected annual total returns for the iShares and Xtrackers ETFs, which expire in a good two to almost three years, are around 3.7 percent. With a term of around five years it is a good four percent. For term ETFs that expire in a good nine and ten years, it is more than four and a half percent.

The returns on the bond market are quite attractive compared to the last ten years. This was emphasized by banks such as Landesbank Baden-Württemberg, Amundi and Lazard Asset Management.

There are clear differences between the two providers mentioned when it comes to quarterly distributions and therefore passive income. iShares distributes a large portion of the interest to investors, while Xtrackers only distributes a portion.

For example, in the case of the iShares ETF, which matures in December 2031 and therefore in just over five years, 0.04 euros are distributed per quarter. With a fund price of currently 4.87 euros, this corresponds to a quarterly distribution yield of a good 0.8 percent and a distribution yield of just under 3.3 percent per year. The interest coupons on the bonds in this ETF average 2.85 percent.

The expected annual return of 4.2 percent and distributions of 3.3 percent per year are above the average coupon rates of the bonds in the ETF. “The yields are currently higher than the average volume-weighted interest coupons because many of the bonds are trading below the repayment value,” explains Blackrock expert Wenicker.

This means: Investors currently earn a higher passive income per month with “iBonds” than by purchasing bonds directly, which only pay the bonds specified in the interest coupons.

Things are a little different with Xtrackers’ term funds. The “Target Maturity” ETFs pay out less per month than they earn from interest coupons. The undistributed interest income thus forms a buffer for the repayments of the ETFs at the issue price.

For example, for the “Target Maturity” ETF due in December 2031, 0.13 euros will be distributed per quarter. With a fund price of 29.26 euros, this corresponds to a quarterly return of 0.4 percent. Extrapolated over a year, the distribution yield is just under 1.8 percent. This is well below the expected total annual return of just over four percent.

Lukas Ahnert, product specialist at Xtrackers, explains it like this: “Our goal is stability, so we calibrate the distributions before we start and try to keep them as constant as possible.”

However, the distributions that investors can expect are nothing more than extra income. For example, investors who invest 15,000 euros in Xtrackers' distributing term ETF, which is due in five years, will receive around 66 euros in February, May, August and November.

Anyone who also invests 15,000 euros in the distributing term ETF from iShares, which is due in five years, will receive around 120 euros in March, June, September and December.

With dividend ETFs, monthly distributions are less reliable. This is shown by a comparison by Handelsblatt: Anyone who invested a total of 30,000 euros in three selected diversified stock ETFs over the past three years received only 46 euros before taxes in the worst month, March 2024, and around 276 euros in the best month, June 2023.

When it comes to passive income with a stock ETF, investors should not only pay attention to the distributions, but also aim to build wealth. It is crucial to look at the dividend payments and the price development together.

With bonds, passive income is also less about the distributions and more about the easy-to-plan repayments, according to Stotz from the Frankfurt School. “They make up a large part of the cash flow that investors generate with bonds,” says the professor of asset management. One strategy is to select bonds so that some of the papers mature regularly. Investors can achieve this not only by investing in individual bonds, but also with broadly diversified term ETFs.