The risks and returns on domestic and overseas bond funds (Part 3 of 7)
Interest rate risk and duration
In the last section, we discussed historical returns for domestic ETFs investing in government bonds like the iShares 7-10 Year Treasury Bond ETF (IEF), as well as international bond funds investing in government securities like the iShare International Treasury Bond ETF (IGOV), the Emerging Markets Sovereign Debt Portfolio ETF (PCY) and the SPDR Barclays International Treasury Bond ETF (BWX). In this section we will cover the risks inherent that come with these ETFs.
These funds are similar in terms of their durations, which range from 6.95 years for IGOV, to 8.63 years for PCY. Durations measure price sensitivity in bonds due to parallel shifts in the yield curve. The higher the bond or the bond fund’s duration, the greater the price change for a given change in the interest rate, all else constant. So, interest rate risk is highest for PCY and lowest for IGOV amongst the funds considered, in terms of duration.
Standard deviation of returns & Sharpe ratio
The standard deviation of fund returns and the Sharpe ratio, provide assessments of the risks taken by the fund to earn the returns. The standard deviation of returns over the past three years, which measure how much the historical fund returns have fluctuated around its mean, is the lowest for IEF and BWX at 6% and 6.65%, respectively, while it is the highest for PCY at 9.32% (source: Yahoo Finance, April 29, 2014).
The Sharpe ratios measure whether the returns earned on the fund are commensurate with the risks taken to earn them. The Sharpe ratios for the above-mentioned funds are based on returns earned over the past three years. These are the highest for IEF at 0.8. PCY is not far behind at 0.76. BWX has the lowest Sharpe ratio at 0.18 (source: Yahoo Finance, April 29, 2014).
Currency risk is zero for both PCY and IEF, since both funds invest in U.S. dollar-denominated securities. Both BWX and IGOV invest in bonds that are denominated in local currencies, which makes them subject to currency risk. In the event the U.S. dollar appreciates, the value of the underlying bonds will decline in U.S. dollar terms, all else equal. The reverse is true if the U.S. dollar depreciates. Domestic bond funds like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), which invest in domestic corporates, will also have zero currency risk for the U.S. investors.
Country risk, that is, risk arising from the economic and political environment of a country, is generally perceived to be the lowest for the U.S. International funds, PCY, BWX, and IGOV will be subject to higher risks arising from the economic and political environment of the countries whose governments are issuing the bonds, for example, elections in India, geopolitical tensions in Russia-Ukraine, Balance of Payments situation in Argentina, etc. Due to this reason, international investments often require an additional “country-risk premium or spread” to compensate them for the higher risk involved in overseas investments.
These risks are perceived to be lower for developed economies compared to Emerging Market economies. Plus, BWX and IGOV have ~22.8% of their holdings invested in Japanese government bonds, which make them more vulnerable to changes in Japan’s economic environment. The top country allocation for PCY is 4.64% (Turkey). While one might argue that Japan has lower country risk than Turkey, the high percentage of Japanese holdings may skew the portfolio performance for BWX and IGOV.
Sovereign or credit risk
Sovereign risk is the risk that a national government will fail to make timely payments on debt issued by it or actually default on its debt obligations. IEF has a fund rating of AA-f, while IGOV has a fund rating of A-f by S&P. About 35% of PCY’s bond holdings were rated below BBB by S&P (as of March 31, 2014), which would imply that its credit risk is higher than that of the other funds, to that extent. All of BWX debt issues are rated BBB or higher (quality classification as per Barclays).
Which fixed income ETF investing in Treasuries best suits your needs?
For those investors looking for a secure investment in the international bond market, and at the same time, looking to diversify their portfolio and hedge the U.S. dollar exposure, IGOV, appears to be the best fit amongst the four funds considered. For investors with higher-risk appetite and looking for portfolio diversification by investing in international bond funds, PCY appears to be the better option amongst the four funds considered, as it has relatively higher historical returns and Sharpe ratio. The expense ratio is lower for IGOV compared to PCY (0.35% compared to 0.50%).
In the next part, we will discuss domestic and international bond funds that invest in corporate debt.
Browse this series on Market Realist:
- Part 1 - The risks and returns on domestic and overseas bond funds
- Part 2 - Sovereign international bonds versus the US Treasuries: The returns
- Part 4 - International and domestic corporate bond funds: The returns
- Interest rate risk
- Currency risk
- Country risk
- Sharpe ratio