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Fixed-income ETFs in vogue as experts see market drop

Nicki Bourlioufas  |  09 Oct 2017Text size  Decrease  Increase  |  
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Investors are increasingly investing in fixed-income exchange-traded funds (ETFs), some of which may help to protect against a potential share market sell-off, with several new products having launched on the ASX this year.


Bonds offer investors a relatively safe place to invest their money compared to equities. When share markets sell off, investors typically switch out of equities to bonds, especially government bonds, because bonds are less volatile and pay regular interest.

While government bonds pay interest bi-annually, corporate bonds issued by companies often pay interest quarterly. Managed bond funds or ETFs may pay distributions monthly.

David Sokulsky, chief investment officer with Crestone Wealth Management, expects share prices could fall in coming months and suggests investors take a more defensive positioning. He believes equities are overvalued, with poor earnings growth and higher interest rates and other global factors expected to weigh on values.

"In Australia, aggregate valuations are akin to those offshore with seemingly little upside remaining ... the Australian market appears to be fully valuing the upside. However, arguably, it's not pricing in the downside risk given the weak consumer, risk of a housing downturn, and market concentration," says Sokulsky.

Risks to markets include the outbreak of war between the US and North Korea, a Chinese debt crisis, tighter rates in the US and other developed nations, and Trump-induced political risk and the debt ceiling.

Investors have become complacent about risk, which has created a greater risk of a shock to markets, says Sokulsky.

"Domestic risk is marginally higher than offshore given the weakness of the domestic consumer and our reliance on China and housing for much of our economic growth," he says.

"While we don't think there is cause for major concern, we do think now is the time to be positioned more defensively and to act prudently when taking risk."

Investing in fixed-income ETFs is one option for investors, with several having launched on the ASX in recent months. These include cash ETFs and bond-backed ETFs.

"A plethora of cash, short-term, and floating-rate ETFs launched recently, all offering parking spots for your money. It's tempting to simply pick the fund with the highest yield, but the products are not interchangeable," says Alexander Prineas, an associate director, manager research, at Morningstar.

"Fees and investments vary, and the old rule of 'the higher the return, the higher the risk' remains relevant. These funds are conservative versus equity and longer-dated bond ETFs, but even so, investors need to know what they're getting into."

Australian fixed-income assets made up 11.5 per cent of assets backing ASX-listed ETFs as at 31 August 2017, up from 10.8 per cent as at 30 June 2017, and up from 8.5 per cent of total ETF assets in June 2015, according to the ASX Monthly Funds Statistics. Global fixed-income assets backed no ASX ETFs in June 2016, but backed 1.2 per cent of listed ETFs by August 2017.

Over the same period, Australian equities accounted for 36.1 per cent of listed ETFs assets as at 30 August 2017, down from 37.2 per cent as at 30 June 2017, and down from 40.1 per cent in June 2015.

According to Prineas, the whole ETF market is growing, but the fixed-income part of the market is growing more rapidly than equities after several new products launched this year.

For those investors looking to buy into fixed-income ETFs, there are several factors to consider.

"Investors shouldn't just buy based on yield as generally speaking the higher the yield, the higher the risk. Investors should delve into the underlying investments and understand the interest rate or duration risk of the underlying assets," Prineas says.

Duration risk is the risk that higher interest rates will erode the value of fixed-rate bonds. The higher a bond's duration, the greater its sensitivity to interest rates changes.

For investors concerned about rising interest rates, Prineas says they may be attracted to two new floating-rate ETFs which have listed on the ASX in recent months. Floating rate notes are where the bonds' coupons rise with higher market interest rates, helping to preserve the value of the bond in a rising rate environment.

"The threat of higher interest rates could be pushing the popularity of these ETFs," he says, referring to two new launches, the BetaShares Australian Bank Senior Floating Rate Bond ETF (ASX: QPON) and the VanEck Vectors Australian Floating Rate ETF (ASX: FLOT).

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

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