In the past month, US treasury ETFs have sold despite aggressive buying from the Federal Reserve. International bond ETFs have fallen too. Will international bond ETFs continue to follow treasuries?Traditionally U.S. treasury bond ETF investors have had two worries: rising rates and inflation. International bond ETF investors have always factored in a third concern: sovereign default. The issue impacted relative performance in the spring of this year. Investors worried that Greece and Spain might have to restructure. This caused a divergence in the treasury and international fixed income markets.The chart below shows this. It compares the 1-year return of an international bond ETF, SPDR Barclay's Capital International Treasury Bond (NYSEArca:BWX - News) with the iShares 7-10 Year Treasury Bond ETF (NYSEArca:IEF - News).
The comparison is not perfect. BWX has a duration of about 6.5. IEF is about 7.5. The yields of these two funds are different. But the chart shows the basic configuration. In April 2010, confidence in the euro eroded. The markets turned to the dollar and treasury bonds for safety. U.S. treasury ETFs gained on international bond funds. This divergence happened in spite of the fact that most of the holdings in BWX are either German or Japanese, not Greek or Spanish. If BWX had significant holdings in bonds of these countries, the impact would have been more dramatic. BWX has recovered about half of its divergence since the widest point in July.Default is always a serious risk for sovereign debt but international bonds have had a great run. Prior to Greece in 2010, investors in international debt have had reason for complacency . Since 1998, when the Russian government defaulted on its GKO bonds, defaults tended to decrease. Only in the worst months of the financial crisis in 2009 did default seem a serious threat. Fewer defaults drove down yields. For the U.S. investor, ETFs holding bonds denominated in foreign currencies boasted the additional advantage of gains from local currency appreciation. With the dollar in long-term decline, coupon payments in foreign currency became ever more valuable in dollar terms.The US is not at risk of default. The Federal Reserve has a zero interest rate target and a massive program to buy treasuries. Inflation is flat, by some measures negative. There is no sign of inflation on the horizon. Nevertheless, treasury prices are volatile and falling. A key reason here is that investors in treasury bond ETFs are worried about valuation. They are worried about mushrooming U.S. debt obligations soon approaching 100% of GDP. There is no default risk on treasuries because in order to meet its obligations the U.S. treasury need not restructure. Merely printing money would do it. But in big numbers this would be tantamount to default. As a result, when the market deems this a possibility, price action on treasury bonds has default risk characteristics familiar from foreign sovereign debt.While traditionally foreign sovereign debt has involved more risk compared to treasuries, some international debt today seems safer than U.S. bonds. US debt as a percentage of GDP is forecast to grow rapidly in the next decade hitting and passing 100% of GDP. Germany's debt though enormous is expected to be stable at about 70%. Canada's debt, for example, is also forecast to be stable and to hover around 30% of GDP.Although in these and other cases international debt may be more secure or more fairly valued than U.S. treasuries, the bad news is even so bonds look expensive. Some investors argue that they should be expensive. There is no sign of inflation. World economies, including China, have massive overcapacity. US consumers are saving more and paying down debt. The "new normal" for growth means that investors should get used to lower returns. But bonds at these high levels do involve risk. U.S. and foreign treasuries are borrowing at record levels. If rates rise in 2011, as many expect, the impact will be global. It will hurt investors in treasury ETFs and in international debt ETFs alike.Ultimately, there are better opportunities in equity than any fixed income products right now. Smart investors will cut or hedge exposure to fixed income products including international bond ETFs. For investors who want fixed income, its probably worth giving up yield for shorter duration.International Bond ETFs:
SPDR Barclay's Capital International Treasury Bond (NYSEArca:BWX
), 0.5%iShares S&P/Citi International Treasury 1-3 Year Bond (NasdaqNM:ISHG
), 0.35%Emerging Market Focus:
PowerShares Emerging Mkts Sovereign Debt (NYSEArca:PCY
), 0.5%iShares JPMorgan USD Emerging Markets Bond (NYSEArca:EMB
), 0.6%Market Vectors Emerging Markets Currency Bond (NYSEArca: EMLC
SPDR Deutsche Bank International Government Inflation Protected Bond (NYSEArca:WIP
), 0.5%Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.