Fixed Interest – Australia ETFs, funds & risks

There are many risks to investing in Australian bond ETFs. You should always consult a licensed and trusted financial adviser before doing anything. This information is general information and should not be considered personal financial advice.

Here are some of the risks:

• Index risk – Unlike sharemarket indices (e.g. ASX 200), most bond market indices use an incredibly poor construction methodology. In the sharemarket, the biggest companies get a bigger weighting in an index because they are valued by their market capitalisation (number of shares x total shares). This rewards a company for growth. However, in the bond market, most indices use the total amount of debt to weight companies in the index. Meaning, companies with the most debt are the biggest part of the index (and hence part the index fund ETF). As you can imagine, lots of debt can be a bad thing!
• Liquidity risk – Unlike shares, some bonds trade infrequently. For example, many big pension funds or investors will buy a bond and never sell it (they’ll just collect the coupon payments until it matures). A problem arises because ETFs need to let investors in-and-out (buy and sell) each day. If the ETF issuer can’t buy the bonds in the index for you, they’ll have to find other ways to provide the bond market exposure. Ultimately, this ‘lack of liquidity’ means the ETF’s unit price can deviate from the value (NTA) of the bonds (called a “premium” or “discount”). For this reason, you need to pay careful attention to the ETF’s discount and premium when you’re buying or selling and consider sticking to reputable ETF providers. This risk tends to be worst during a market crash or a rapid recovery – when trading activity steps up.
• Concentration risk – Diversified portfolios balance their exposure across many different issuers, sectors, countries and credit ratings. That is, owning bonds issued by companies or countries from just one sector or geography can create unnecessary risk. In Australia, the bond market is heavily skewed towards corporate bonds. That is, bonds issued by big companies. And within the corporate bond sector, many of those bonds are issued by Australia’s banks (Commonwealth Bank, ANZ, Westpac, etc.). If too much of a bond portfolio is concentrated towards one sector of the market, an investor may be overly exposed to risks only in that sector. That’s we think it’s best for bond portfolios to be evenly diversified across all markets, bond types, issuers, industries and credit ratings.
• Credit risk – Companies and countries that issue bonds are ‘rated’ by expert credit rating agencies (S&P, Fitch, Moody’s, etc.). If there’s a big chance the company/government could go bankrupt, the bond will have a lower/worse credit rating (e.g. CCC). The safest bonds are issued by stable governments and given a ‘AAA’ rating. “Junk bonds” are typically rated BBB- or lower and have a higher chance of default.