[Editor’s Note: Do not read the following article as a recommendation to invest in fixed or floating-rate bonds, or fixed-interest ETFs. Like all investments, bonds have risk. They include the possibility of default from some issuers and changes in interest rates. Risks of fixed or floating-rate ETFs can also include liquidity, concentration or credit risks. ASX information on Investing in Bonds explains the features, benefits and risks of this form of investing. The free ASX online course on bonds is another useful resource for investors new to bonds. Talk to a licensed financial adviser or do further research of your own before acting on information or themes in this article].

Fixed-income exchange traded products (ETPs) on ASX have continued to increase in popularity with the industry growing to $22.6 billion at end-July 2023, from $16.1 billion at end-July 2022, according to the ASX Investment Products report.

Fixed income ETPs now make up 15% of the total fixed income industry, according to VanEck analysis. Australian fixed income strategies, particularly those that are short duration, have taken the majority of flows into fixed-income ETFs.

Understanding fixed-rate and floating bonds 

Fixed-rate and floating-rate bonds are two types of debt securities issued by governments and companies as a source of financing.

A fixed-rate bond means the coupon or interest rate paid over the life of the bond, say five years, is predetermined and fixed for the term. When you invest in a fixed-rate bond, you know exactly how much interest you will receive at regular intervals until the bonds maturity date. Fixed-rate bonds carry interest-rate risk. Bond prices appreciate when interest rates fall and vice versa. 

A floating rate bond means the coupon or interest rate varies according to a short-term benchmark interest rate, such as the Bank Bill Swap Rate (BBSW) in Australia. The interest on the floating-rate bond is adjusted periodically (e.g., quarterly) based on changes in the benchmark rate. Floating rate bonds have lower sensitivity to interest rate movements.
 

Factors affecting a bond’s market price

The market price of a bond will vary over time depending on what's happening in the economy and with interest rates, as well as any changes in the creditworthiness of the borrower. If a borrower’s perceived probability of default increases, then the prices of its bonds will fall.

The choice between fixed-rate and floating-rate bonds depends on an investor’s risk appetite, market outlook and income preferences.

For investors looking for protection against rising interest rates, floating rate bonds are designed to adjust their interest payments based on changes in a benchmark interest rate. This means that as interest rates rise, the coupon payments on floating rate notes increase, providing a degree of protection against the negative impact of rising rates.

For investors who think interest rates are likely to decrease, a fixed rate bond ETF may be more appropriate, in VanEck’s opinion. If interest rates decrease, the value of existing bonds in the ETFs portfolio may rise, potentially leading to capital appreciation.
 

Using ETFs for fixed income exposure

Fixed income ETFs offers several advantages including diversification, liquidity, transparency, flexibility and they are generally cost effective. ETFs:

• provide access to a basket of fixed income and credit securities with exposure across multiple issuers and maturities, minimising the credit risk associated with individual bonds. 
  
  
• trade on exchanges like individual shares. This means investors can buy or sell ETFs throughout the trading day at transparent market prices, providing flexibility and ease of access.
  
  
• provide investors with a high level of transparency. Typically, an ETF’s list of securities is available on the fund manager’s website.

Fixed or floating rate ETFs on ASX 

There are a number of ETFs on ASX that provide access to both floating and fixed rate bonds. One of the benefits of investing in either fixed rate and/or bonds via an ETF is that it enables investors to get exposure to a diversified portfolio of bonds in a single trade.  

The wide range of fixed income ETFs available on the ASX allows investors to tailor their investment portfolio to target specific sectors (e.g., banks), regions (e.g., Australia) and/or credit tranche (e.g., subordinated debt).

As ETFs follow a set of rules which is referred to as an “index”, they are typically able to ensure costs remain low as they aim to replicate the performance of index as opposed to outperform the chosen benchmark. 

As a result, ETFs charge management costs which are generally lower compared to “actively managed” funds, which have a manager or management team that makes decisions about how to invest the fund’s money to exceed a prescribed benchmark. 

Finally, fixed income ETFs can be purchased in small quantities, making them accessible to a broad range of investors. They are easily bought and sold via online trading accounts, full service brokers or through financial advisers.
 

Risks with fixed income ETFs 

The main risks investors should be aware of when investing in fixed income ETFs are the respective benchmark they track and the interest rate, counterparty or credit risks. 

As mentioned earlier, fixed income ETFs are sensitive to changes in interest rates. When an investor invests in a fixed-rate bond ETF and rates rise, the prices of bonds in the ETF’s portfolio will generally fall. 

Conversely when interest rates decline, fixed rate bond prices tend to rise, benefiting investors. Interest rate risk also increases the longer the average time to maturity.

Investors should also be aware of credit risk. Fixed income ETFs hold bonds issued by governments or companies. If an issuer’s perceived risk of default increases, the value of the bonds held by the ETF may decrease, and investors could subsequently bear losses. Credit rating of a bond is influenced by credit rating, seniority, issuer-specific and macroeconomic developments.

Importantly, fixed income is an Over The Counter (OTC) market and it is important for investors to understand the size of this market and the types of investors who participate in what is known as the primary market. In times of market stress, investors should expect fixed income ETF spreads to reflect that over the OTC market - thus giving them a price-discovery mechanism.

Diversification and understanding the structure of the ETF’s underlying holdings can potentially help to mitigate some of these risks.
 

Conclusion

It is essential for investors to conduct thorough research and consider whether the fixed income ETF is right for their individual investment goals and risk tolerance. Always check the label of the ETF you are considering investing in. If you are unclear on anything contact the ETF issuer.