Banking risk in bond funds: A cluster risk that almost everyone overlooks

From Daniel Chancellor  and  Gerd Kommer  

Investing successfully means identifying important risks and managing them appropriately. A type of risk that plays a major role in practice, but to which most private investors pay little attention - unlike "ordinary" price fluctuations and drawdown risks - is cluster or concentration risks in their own asset portfolio.

Cluster risks are often risks that have a “black swan” character, i.e. risks that occur statistically very rarely and whose probability cannot therefore be reliably quantified, but which, when they occur, cause particularly great damage. The author and fund manager Nassim Taleb made black swan risk known to private investors worldwide with his book “Black Swan: The Impact of the Highly Improbable” in 2007, just in time for the beginning of the “Great Financial Crisis”.[1] The Great Financial Crisis was a black swan.

“Global risk in Germany” for private investors

Given this background, what do we mean by “cluster risk”? Here is the short case study of the couple Inga (32) and Arno (35). Both are working and live in Rostock. They don't have children yet, but are planning on having one or two. Eight years ago, shortly after their marriage, the couple bought a three-room apartment in the city center for their own use. The apartment is currently worth 600,000 euros, of which 500,000 euros are still financed with a loan. Both spouses have claims to statutory pension insurance, which together currently add up to a cash value (present value) of 80,000 euros. Inga also owns a small stake in the tech startup where she works as an employee. She estimates the value of this investment at 150,000 euros.

After deducting debts, the couple's combined net assets are 330,000 euros.[2] However, without exception, the couple's entire assets are exposed to the "German political risk" or, in financial jargon, "exposed" to the German political risk (see information box below for the concept of political risk). If you also consider that human capital[3] Inga and Arno have a high degree of “Germany exposure”, one can speak of a considerable “cluster risk in the German jurisdiction” with regard to their asset portfolio.

A simple way for Inga and Arno to reduce their concentration risk in Germany would be to sell their apartment. They could use the proceeds to repay the loan and invest the remaining 100,000 euros in a globally diversified stock portfolio - without the Germany risk. They could then live in the same or a comparable apartment for rent.

Cluster risk of the banking sector in private investor portfolios

Another form of cluster risk in the asset portfolio of many private households exists in relation to the banking sector. We will illustrate this again using a small case study. We look at the married couple Marda and Tony. They are both 65 years old and have recently stopped working. Marda and Tony consider themselves risk-averse. You have little experience with the stock market and other high-risk, high-reward investments.

The two have built up a combined net worth of 750,000 euros over the past few decades. It is structured simply: 200,000 euros in a daily money account (the account holders are the two together), two bond funds (bond funds) worth a total of 300,000 euros and a global equity ETF worth 250,000 euros. (We ignore the present value of your statutory pension insurance claims for the purposes of this calculation.)

When they began their retirement a few months ago, the two began making withdrawals from the portfolio to cover their pension gap (the difference between their after-tax pension and living expenses).

Marda and Tony chose to invest in the two bond funds because they are aware that bank deposits of more than 200,000 euros for a married couple are not covered by the statutory deposit insurance, but on the other hand they want to keep the largest part of their portfolio in low-volatility, highly liquid investments. The asset allocation (percentage asset structure) consciously chosen by the couple is two thirds / one third (more precisely 67/33) in the sense of “low risk to high risk” (500,000 euros to 250,000 euros). However, Marda and Tony have a cluster of “banks” risk in their portfolio without being aware of it.

Bank balances and default risk

Where is it? To show this, we have to go back very briefly: Bank deposits above the statutory deposit insurance limit of 100,000 euros per bank-customer combination (200,000 euros for married couples) are high-risk investments - high-risk not in terms of the risk measure of volatility (current fluctuations in value), but high-risk in terms of the risk measure Risk of default (loosely repayment risk). We have this in our recently updated blog post “The underestimated risk of bank deposits“Systemic banking crises have occurred rarely since the beginning of the modern market economy around 250 years ago (as is typical of black swan risks), but are nevertheless “completely normal”.[4] Therefore, no bank deposits should be held in amounts above the mentioned limit.

Marda and Tony also see it that way and therefore limit their daily investments to 200,000 euros. They invested half of the remaining 300,000 euros in the following two bond funds six years ago.

1. UBS Bloomberg MSCI Euro Area Liquid Corporates Sustainable ETF – WKN A2AQ6E (duration approximately 4.8 years)
2. UniEuroKapital Corporates – WKN 136703 (duration approximately 1.8 years)

The first fund is a passive corporate bond ETF, the second is an actively managed corporate bond fund.

At the time, Marda and Tony deliberately chose two funds based on corporate bonds, not government bonds, because the former generate a slightly higher return in the long term and because the couple is concerned about the high level of debt of states in the eurozone.

However, the couple is not particularly satisfied with the return-risk combination of the two funds during the six-year holding period. The two would perhaps be even more dissatisfied if they knew that bonds from the banking sector made up over 50% of the first fund and over 40% of the second (as of January 2025).

This is worrying in two respects: Firstly, that's exactly what Marda and Tony wanted with this money no additional bank counterparty risk and secondly, bank bonds have a higher risk of default than retail customer deposits with a bank.

The “insolvency ranking” in the event of a bank failure

Few private investors probably know the reason: In a bank balance sheet, both customer deposits and the bonds issued by the bank represent liabilities (debts) of the bank. If the bank goes bankrupt, its creditors will be paid from the bankruptcy estate in the following order:

1. Depositors (savers) within the statutory deposit insurance. (In the EU, only these claims are “guaranteed” de facto, if not de jure, by the state.)
2. Depositors (savers) with claims above the statutory deposit protection
3. Creditors of secured bank bonds (especially Pfandbriefe), if the cover pool is not sufficient to satisfy creditors, as well as creditors of normal, unsecured bank bonds (including certificates)
4. Creditors of so-called subordinated (also unsecured) bank bonds
5. Shareholders

This “insolvency ranking” or “liability cascade” results from the EU-wide uniform bankruptcy law for banks, from the national deposit insurance law, from the national Pfandbrief laws and from the contractual conditions of bank bonds.

If there were another systemic banking crisis in the EU like in the years 2008 to 2011, then investors in bank bonds in particular would have to tremble. This is probably the main reason why the UniEuroKapital-Corporates fund collapsed by almost 30% in the 2008 financial crisis, before voluntary state rescue measures by the EU governments and the ECB gradually made it clear from the second half of 2009 that the European banking sector would not collapse completely. Then the prices of bank bonds and those of funds such as UniEuroKapital Corporates with a high proportion of bank bonds began to gradually recover. (The UBS ETF did not exist at that time.)

Not all corporate bond funds - actively managed funds or passive ETFs - have as high exposure ratios to the banking sector as those in Marda and Tony's portfolio, but in most of them the banking sector has a weighting of over 20%. This is due to the fact that the banking industry is generally a large economic sector and holds more borrowed capital (debt) on the balance sheet (is more indebted) than normal companies.

However, since we know for sure that there will be another systemic banking crisis in Europe at some point, in our opinion a rational investor should avoid this type of black swan risk, i.e. not invest in supposedly low-risk bond funds (including money market funds) that contain an excessive proportion of bank bonds.

What about ETFs in the money market segment that reflect a short-term (variable) reference interest rate, i.e. not a bond index? Here, the question of the extent of the bank exposure ultimately depends on the counterparty (usually a bank) and the composition of the so-called security basket, i.e. the bond basket that is pledged to the ETF as a legal entity and serves to secure the swap counterparty's payment obligations to the ETF. As a rule, this security basket consists of short-term government and corporate bonds. The extent to which it contains bank bonds cannot be generalized, as the basket of bonds can be adjusted daily.

Fortunately, this is easy for private investors to implement these days, even without having to go through the hassle of buying individual bonds or expensive, actively managed corporate bond funds.

At our suggestion, the British asset management group Legal & General launched a corporate bond ETF in October 2024 that excludes bank bonds. (Gerd Kommer Invest GmbH came up with the idea for the ETF and GKI also uses it in its own asset management business.) In our view, this ETF is an attractive product option for investors who want to invest part of their funds in a broadly diversified manner in short-term corporate bonds with little interest rate risk and particularly high creditworthiness.

The L&G Corporate Bond ex-Banks ETF

Here is a brief summary of the key features of the ETF (as of January 31, 2025 unless otherwise stated).

The ETF is offered in a currency-hedged euro variant and in a variant without currency hedge. Both variants hold the same underlying bond portfolio of USD bonds and Euro bonds (currently around 74% USD bonds and 26% EUR bonds). In the Euro variant, however, the exchange rate of the USD to the Euro is hedged, so that an investor with the “home currency” Euro has no exchange rate risk here.

• Name: L&G Corporate Bond ex-Banks Higher Ratings 0-2Y ETF
• WKNs: Euro variant of the ETF without exchange rate risk WKN A40E7Q; USD variant with USD-Euro exchange rate risk WKN A40E7P (see explanation above);
• Duration (“remaining term”): approx. 1.1 years (value will fluctuate slightly over time). It is therefore a “money market-related fund” with low interest rate risk;[5]
• Rating range (creditworthiness): AAA to A (the top 7 rating levels of approx. 23). The fund therefore has a higher floor for the credit quality of the bonds it contains than most “investment-grade” corporate bond ETFs;
• Ongoing costs (TER): 0.15% p.a. for the variant with Euro hedge, 0.12% p.a. for the variant without Euro hedge;
• Replication Method: Physical, combined with Optimized Sampling;
• Shown index: J.P. Morgan Global Credit Index (GCI) Ultra Short ex Banks 2% Issuer Capped Index;
• Number of issuers: approx. 130;
• Issuer Cap: An individual issuer is “capped” at 2%, i.e. h. All bonds from this issuer in the ETF can total a maximum of 2% of the fund volume. This avoids concentration risks;
• Minimum size of a bond issue: 300 million USD or euros in order to achieve a sufficiently high level of liquidity and thus low transaction costs for the bonds contained in the ETF;
• Use of income for the interest earned: Accumulating;
• Industries: All industries, excluding banks, but including other financial service providers such as insurance and payment transaction providers;
• Current yield as of February 28, 2025: 3.9% p.a. for the asset class without Euro hedge, and 2.7% p.a. for the EUR hedged share class (this already includes the estimated hedging costs);
• ESG exclusions: Moderate exclusions common to bond funds, e.g. B. for operators of coal-fired power plants, providers of alcohol and gambling, manufacturers of controversial weapons;
• Rebalancing frequency: Monthly;
• Fund domicile (legal seat): Ireland;
• Issue date: October 17, 2024

We believe this corporate bond ETF can be useful for investors who primarily have the following objectives:

(a) ETF variant with currency hedge (WKN A40E7Q):

The ETF is a convenient, low-volatility, near-money market investment that we expect to generate a nominal annual return just above inflation over the long term. As is typical for corporate bonds, the ETF should slightly outperform German government bonds with identical duration in the long term.

The ETF is an investment that can help cushion and diversify the volatility risk of stocks, crypto assets and gold in a mixed portfolio. In a mixed portfolio, it can also supplement any existing government bond component.

In particular, the ETF is a corporate bond fund that excludes the banking sector for strategic and portfolio theoretical reasons (see explanations in the following text). If there is another major systemic banking crisis like the one in 2008 ff. or an even more serious crisis, we expect this ETF to outperform comparable conventional ETFs and actively managed bond funds. Our historical calculations have shown that the index underlying the ETF significantly outperformed its alternative index variant including bank bonds during the banking crisis from 2008 to 2011. After that, his return was slightly lower.

Compared to conventional passively managed corporate bond ETFs with a similar duration, there should be slight underperformance in the long term, as riskier bonds with a BBB rating and bank bonds are deliberately excluded.

In our opinion, however, the ETF has a good chance of beating the majority of all comparable actively managed bond funds in the long term, just as has been repeatedly confirmed in statistical evaluations by scientists and rating agencies over the past decades for passive bond funds. The main reason for this is the significantly lower costs compared to a typical actively managed bond fund.

(b) ETF variant without currency hedge/USD variant (WKN A40E7P):

Calculated in euros, this ETF will be significantly more volatile than the variant hedged in euros. The “USD variant” could be attractive to investors who believe that the dollar will trend up relative to the euro while at the same time the market interest rate level in the dollar area will be approximately the same as in the euro or higher. For a household with the euro as its functional currency (“home currency”), the fluctuations caused by exchange rate risk lead to a loss of the “risk buffer function” of high-quality bonds. However, for the reasons mentioned above, there are investors who consciously do not want to hold too many Eurobonds in their portfolio.

Overall, it can be said that with the end of the “zero interest period” at the beginning of 2022, interest-bearing investments have become attractive again in terms of returns. This can be seen in the nominal current yields of the two ETF variants mentioned above. Consumer goods inflation in Germany is now annualized again at 2.3% (January 2025), close to the ECB's target value. Investors are currently receiving positive real interest rates again.

Conclusion

The relatively slight decline in US stocks and tech stocks since mid-February (as of March 13, 2025) will have reminded some private investors that when investing at the overall portfolio level, the goal should not only be to maximize returns, but also to limit drawdown risks and volatility. High clusters in individual sub-segments of the global stock market (USA, Tech) mean more risk. This probably applies even more to high concentrations in the banking sector.

It is encouraging that risk reduction through short-term high-quality bonds can now be achieved again at attractive real returns.

We believe that the new Legal & General ETF profiled here is an option worth considering for investors who have such a risk buffer with high liquidity in their portfolio and who would like to use it to reduce their banking sector exposure.

In order to avoid any misunderstandings, we would like to emphasize at this point that Gerd Kommer Invest GmbH or persons and companies closely related to it do not receive any remuneration or commission from the L&G ETF listed above - neither in the past nor in the future.

We recommend our following blog posts to readers who would like to take a closer look at the exciting topic of bonds:

• „Bonds as an asset class: From the basics to specialist knowledge”
• „Money market funds – the smart alternative to overnight money
• „Inflation-indexed bonds – how well do they protect against inflation?”
• „The interest rate risk for bonds
• „Bonds and interest rate changes – a case study”

Endnotes

[1] The German translation of the book is titled “The Black Swan: The Power of Highly Improbable Events.”

[2] 600,000 euros minus 500,000 euros plus 80,000 euros plus 150,000 euros.

[3] Human capital is the present value of the labor of a person or a household, i.e., to put it simply, the sum of all net income that a specific person or the household will receive until the expected/probable end of working life. The Nobel Prize winner in economics Gary Becker (1930 – 2014) popularized the human capital concept in economics.

[4] The last systemic banking crisis took place between 2008 and 2011. During this crisis, dozens of small, medium-sized and large banks in Germany, Europe and around the world went bankrupt or de facto bankrupt and had to be saved from insolvency by competitors or the state.

[5] Interest rate risk: If market interest rates rise, the price of a long-term bond will fall. This risk hit e.g. B. in 2022 with the increase in interest rates at that time.