Fixed Interest International ETFs, funds & risks

There are many risks to investing in international bond ETFs and funds. 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 (note: it’s not a complete list):

• Index risk – Unlike sharemarket indices (e.g. S&P 500), 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.
• 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.
• Sovereign/regulatory risks – Governments and regulators throughout the world can change their policies on investing, taxes and even the rights of people and investors. Australia has a very stable and robust financial, legal, political and societal system — many countries don’t. This could adversely affect the risk associated with even the most diverse bond portfolios.
• FX/currency risks – A big reason many investors put their money overseas is to get exposure to another country’s currency. For example, if you invest 1 AUD into US Dollars at a currency exchange rate of 1.00, you will get 1 USD in return. If the USD gets stronger (meaning the Aussie dollar exchange rate falls), your 1 USD is now worth more! However, it can go in the opposite direction. For example, if the AUD-USD goes to 1.10, your 1 USD (bought at a lower exchange rate) is now worth less in AUD terms than before. This risk is the reason why some global bond ETFs are currency ‘hedged’ — to avoid the impact of currency fluctuations.
• Geopolitical risks – This risk reflects the stability of global politics, conflicts and trade tensions between countries and states. The prices and performance of bond investing ultimately come back to the changes in credit ratings, or the creditworthiness of the issuer (banks, governments, etc.). For example, if the credit rating of a country is really bad and investors think that it’s going to default on its debt, the price of their bonds will fall. However, if that country fixes its problems, the bonds will get a better credit rating from the credit rating agencies and will be worth a lot more. Unfortunately, these issues are very difficult to predict and can go in the opposite direction!