The risks and returns on domestic and overseas bond funds (Part 7 of 7)
Interest rate risk and duration
In the last part of this series, we discussed historical returns for aggregate bond ETFs investing in both government (TLT) and corporate bonds (BND) like the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), the iShares Total U.S. Bond Market ETF (AGG), and the Vanguard Total International Bond ETF (BNDX). In this part, we will cover the risks inherent in these ETFs.
EMB has a higher effective duration (7.2 years) compared to AGG (5.2) and BNDX (6.7). Durations measure price sensitivities in bonds due to parallel shifts in the yield curve. The higher the bond or the bond fund’s duration, the greater is the price change for a given change in the interest rate, all else constant. So, the interest rate risk is highest for EMB and lowest for AGG amongst the funds considered, in terms of duration. For more on duration and how it affects your fixed income portfolio, read Interest rate risk: Measure and avoid the pitfalls of duration.
Standard deviation of returns and Sharpe ratio
The fund returns’ standard deviation and the Sharpe ratio, provide assessments of the risks taken by the fund to earn the returns. The returns’ standard deviation over the past three years, which measure how much the historical fund returns have fluctuated around their mean, are estimated at 2.84% and 8.33% for AGG and EMB, respectively (source:Yahoo Finance). Since BNDX is a new fund, comparable figures are not available. So, risk appears to be the lower for AGG compared to EMB in terms of standard deviations.
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 estimated at 1.2 and 0.76 for AGG and EMB respectively (source:Yahoo Finance). So, the risk-adjusted performance appears to be higher for AGG compared to EMB in terms of the Sharpe ratio.
Currency risk is zero for AGG since the fund invests in domestic debt securities which are U.S. dollar denominated. Both EMB and BNDX invest in bonds that are denominated in currencies other than the U.S. dollar, which makes them subject to currency risk. With BNDX, hedging strategies are being used to overcome this risk. So, currency risk will be reduced to the extent these are successfully implemented. For EMB, in the event the U.S. dollar appreciates, the value of the investment will decline in U.S. dollar terms, all else equal. The reverse is true if the U.S. dollar depreciates.
International funds, EMB and BNDX will be subject to higher country risk compared to AGG, since the latter invests in domestic bonds and the U.S. is generally perceived to have the lowest country risk in the world. Overseas investments command a country-risk premium to compensate them for the higher risks. Top country holdings in EMB and BNDX are Turkey (~6%) and Japan (~22%), respectively.
Credit risk is the risk that arises when an issuer fails to make timely payments or defaults on its debt obligations. EMB’s fund rating is below investment-grade (rated BB-f by S&P). EMB has a higher proportion of its holdings invested in non investment-grade and unrated debt (~45%) compared to AGG (~3%) and less than 1% for BNDX, which makes EMB riskier in terms of credit risk.
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