Fixed income ETFs are popular additions to diversified portfolios — but they behave very differently to share ETFs. Understanding duration, yield, and credit risk is essential for anyone considering bond ETFs. This article explains these concepts in plain English for Australian investors.
What Does “Fixed Income” Mean?
Fixed income refers to investments that pay a predetermined, fixed rate of return. The most common fixed income instruments are bonds — loans made by investors to governments or corporations. The borrower agrees to:
- Pay regular interest (the “coupon” rate)
- Return the principal at maturity
“Fixed income” is the broader category that includes:
- Government bonds (issued by the Commonwealth of Australia, state governments)
- Corporate bonds (issued by companies like Telstra, BHP, the Big Four banks)
- Inflation-linked bonds (coupon and/or principal linked to CPI)
- Floating rate notes (interest rate adjusts with a benchmark)
Duration — The Most Important Concept for Bond ETF Investors
Duration measures how sensitive a bond or bond ETF’s price is to changes in interest rates. It is expressed in years.
The rule of thumb:
- If a bond ETF has a duration of 5, a 1% rise in interest rates causes approximately a 5% fall in the ETF’s price
- If a bond ETF has a duration of 5, a 1% fall in interest rates causes approximately a 5% rise in the ETF’s price
Duration examples on the ASX:
| ETF | Duration | Sensitivity |
|---|---|---|
| AAA (cash ETF) | ~0.1 years | Minimal — almost no price change with rates |
| QPON (floating rate) | ~0.1 years | Minimal |
| BILL (T-bills) | ~0.3 years | Very low |
| VAF (broad Australian bonds) | ~7 years | Significant |
| VBND (global bonds) | ~8 years | Significant |
The 2022 lesson: When the RBA raised rates from 0.10% to 4.35% (a rise of ~4.25%), VAF’s unit price fell approximately 12–15% — reflecting its ~7-year duration multiplied by the rate increase.
Yield to Maturity (YTM)
Yield to maturity is the total expected return if you hold a bond (or the average bond in a bond ETF) to its maturity. It accounts for:
- The current price of the bond
- The coupon (interest) payments
- The difference between the current price and the face value at maturity
YTM is the standard measure of a bond’s prospective return. When bond prices fall (due to rising rates), YTM rises — meaning higher future returns for investors who buy at the new lower price and hold to maturity.
Current context (2026): Australian 10-year government bond yields are approximately 4.0–4.5%, up significantly from the 0.5–1.0% yields of 2020–2021. This means bond ETFs like VAF now offer meaningfully higher prospective yields than in the low-rate era.
Credit Risk — Government vs Corporate Bonds
Credit risk is the risk that the bond issuer cannot repay the principal or interest (default risk).
| Bond type | Credit risk | Yield premium |
|---|---|---|
| Australian Commonwealth Government | Very low (AAA-rated) | None — the benchmark |
| State government (semi-government) | Very low (AA-rated) | Small premium |
| Investment-grade corporate | Low to moderate (BBB- to AA) | Moderate premium |
| High-yield (“junk”) corporate | Moderate to high (below BBB-) | Significant premium |
Most Australian bond ETFs (VAF, IAF, AGVT) hold only investment-grade bonds — no junk. VAF includes some corporate bonds (which carry more credit risk than government bonds) in addition to government bonds.
Inflation Risk
Fixed income investments carry inflation risk — rising inflation erodes the purchasing power of fixed interest payments. If you hold a bond paying 3% and inflation rises to 5%, your real (inflation-adjusted) return is negative.
Inflation-linked bond ETFs (e.g., ILB — iShares Australian Inflation ETF) attempt to address this by linking principal to the CPI. These are more complex instruments than standard bond ETFs.
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Frequently Asked Questions
What is the difference between yield and distribution yield in a bond ETF? The distribution yield of a bond ETF is the annualised cash income paid to unit holders, expressed as a percentage of the current unit price. The yield to maturity (YTM) is the expected total return if the underlying bonds are held to maturity, accounting for price changes as bonds move toward par value. For a bond ETF trading at a discount (bonds fell in value when rates rose), the YTM will typically be higher than the distribution yield.
Can I lose money in a bond ETF? Yes. Bond ETFs can lose capital value when interest rates rise (as happened in 2022). They are not equivalent to a bank term deposit or high-interest savings account. However, the capital loss is typically offset by higher future interest income (because the portfolio now holds bonds at higher yields). For investors who hold for long enough, the total return (capital + income) should reflect the YTM at time of purchase.
What is “investment grade” in bond ETFs? Investment grade refers to bonds rated BBB- or above by major rating agencies (S&P, Moody’s, Fitch). These bonds have low-to-moderate default risk. Bonds rated below BBB- are called “high yield” or “junk bonds” — they carry higher default risk and higher yield to compensate. Most Australian bond ETFs (VAF, IAF) only hold investment-grade bonds.
This article provides general financial information only. Bond investments involve interest rate risk and credit risk. For advice tailored to your situation, speak with a licensed financial adviser. You can find one through the ASIC financial advisers register or MoneySmart.