ETF opens the way

Let's start with the basics. What exactly is an ETF and why should I use it to buy fixed interest? To cut the jargon, an ETF is an exchange-traded fund - an investment fund that's listed on the stock exchange. ETFs differ from traditional managed funds in two ways. First, they are listed, which means you can trade them rather than buying and redeeming units through the fund manager, and, secondly, they tend to be passive investments - holding securities that reflect the performance of a particular commodity or index rather than trying to add value through active fund management. They're also much cheaper than managed funds.

Until recently, ETFs in Australia were only available over investments such as shares, currencies or commodities such as gold. But a recent rule change by the Australian Securities and Investments Commission has opened the door for the trading of fixed-interest ETFs - funds that invest in debt securities such as bonds.

Are they available now? None have been issued yet but it is expected they will start to hit the market in the next couple of months. The head of product management and development at Vanguard, Robyn Laidlaw, says fixed-interest ETFs have become increasingly popular overseas in recent years and make up about 17 per cent of the total ETF market in the US.

She says investment advisers and their clients have been using them to diversify their portfolios into fixed interest while still using the equity trading market. Not surprisingly, they have become increasingly popular since the global financial crisis with investors looking for more conservative assets to reduce their overall level of risk.

How will they work? It's likely the first products will be fairly simple offerings tracking a government bond index. Laidlaw says indexes such as the UBS Composite Bond Index and the UBS Government Bond Index are widely used, have a long history and offer underlying liquidity. The composite index measures the performance of a wide range of bonds, while the government index tracks bonds issued by domestic governments.

She says managers tracking these (or other) indexes are likely to hold the underlying bonds included in the index and only buy and sell as the composition of the index changes, which means they are also likely to be tax-effective for investors as the manager is not continually realising profits. Some managers may choose to issue partly or wholly "synthetic" ETFs, where they gain exposure to the index through other means such as derivatives contracts but it's expected the initial offerings are more likely to physically hold the underlying bond investments.

While fixed-interest indexes don't have the same public profile as sharemarket indices, she expects investors to become more aware of them as the market develops.

Will they be risky? Fixed-interest ETFs should reflect the returns of the bond market. While less volatile than shares, bonds can generate losses especially in times of rising interest rates and inflation. On the upside, this means they can also generate profits (in excess of the interest rate or "yield" on the underlying bonds) when rates are falling. Fixed-interest investments can also generate losses when the underlying borrower defaults on their loan - though the risk of this is obviously lower with funds that restrict themselves to Australian government bonds than funds that invest in lower-grade debt securities.

Laidlaw says after the GFC many investors are concerned about liquidity risk - or the extent to which you can get out at a fair price if markets fall. She says because ETFs invest in the securities in an underlying index, an ETF should be as liquid as that index.

She explains that ETFs are open-ended funds, which means the manager can issue new units or redeem existing ones to manage demand from investors, ensuring the ETF produces index returns.

Laidlaw believes the key elements investors will want with fixed-interest ETFs are high-quality securities, liquidity and diversification across the term of the underlying securities and the credit spectrum.