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The Fundamentals of Fixed Income ETFs

  • The onset Global Financial Crisis in 2007 and the subsequent share market volatility refocused investors’ thinking towards the role fixed income could play in achieving investment objectives.
  • The fundamental relationship in bond valuation is that between a bond price and interest rates. In general, as market interest rates rise, bond prices fall, and vice versa.


By the Numbers: A snapshot of current managed account users*

In Australia, fixed income as a defensive asset class has not normally received as much attention as its equity counterpart. This is in part due to the strong returns exhibited in the equity market between 2002 and 2007. But the onset Global Financial Crisis in 2007 and the subsequent share market volatility refocused investors’ thinking towards the role fixed income could play in achieving investment objectives.

Key Features of Fixed Income Instruments

The Australian bond market is dominated by governments, government sponsored entities (such as building societies) and corporations. The example below explains the main features of a bond.

 

The Fundamentals of Fixed Income ETFs

 

How Do You Price a Bond?

Bonds mostly trade in the over-the-counter (OTC) market, and as such, pricing is not readily available. Three common metrics that indicate the market’s price expectations of a bond are:

  • Bond Price: Often this is an average of OTC prices traded throughout the day. If the bond price is above face value, it is said to be ‘trading at a premium’; if it is below face value, it is said to be ‘trading at a discount’; if it is at face value, it is said to be ‘trading at par’.
  • Current Yield: The current or ‘market’ yield refers to the annual yield an investor should expect to receive at the current market price.
  • Yield to Maturity: The yield to maturity is the annual yield an investor should expect to receive should they hold the bond until maturity. It takes into account the purchase price, the value of all remaining coupons and any capital gain or loss associated with the face value being returned at maturity.

Bonds mostly trade in the OTC market, and as such, pricing is not readily available.

What Impacts the Price of a Bond?

There are several factors that can influence bond pricing:

  1. Interest Rates

The fundamental relationship in bond valuation is that between a bond price and interest rates. In general, as market interest rates rise, bond prices fall, and vice versa.

If the coupon rate paid on the bond is higher than the market interest rate, the bond should trade at a premium. If it is less than the market interest rate, it should trade at a discount, all else being equal.

 

Figure 2 Fundamentals of FI ETFs

 

2     Credit Quality

In general, bonds issued by the Commonwealth Government are regarded as risk free as the probability of default is very small. This is because the Government can always use taxes to raise revenue to repay debt.

But issuers such as banks cannot raise taxes and therefore their probability of default is higher. The higher an issuer’s credit risk, the higher the yield the issuer must offer to attract investors.

3    Maturity

The maturity date of a bond is underpinned by the yield curve. The yield curve gauges market expectations about future interest rates by plotting the yield-to-maturities ofvarious bonds at staggered maturities.

A ‘normal yield curve’ shape can suggest stable economic conditions and normal forecasted growth rates. Hence shorter dated securities are expected to receive lower yields than longer dated securities, reflecting a stronger chance of receiving the face value at maturity. Conversely, the increased uncertainty in relation to market conditions in the future imply that longer dated securities should carry a higher yield.

In contrast, an ‘inverse yield curve’ arises from extraordinary market conditions where volatility governs current investor sentiment. In this case, shorter dated securities generally attract higher yields than longer dated securities, as the market expects interest rates to decline over time following the current adverse market conditions.


Fixed Income: a Way to Defend Your Portfolio?


Fixed income has the ability to play numerous important roles in a portfolio. For many investors, the role of fixed income is to dampen overall risk, which means a fixed income allocation acts as ballast during times of heightened market volatility.

Fixed income can allow some level of capital preservation and provide a predictable income. While cash offers capital protection as well, returns may be lower, and in periods of inflation, it could erode in value.