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Looking Overseas For Fixed Income

Todd Rosenbluth

Todd Rosenbluth is director of ETF and mutual fund research at CFRA.

After years of underperforming U.S. alternatives, so far in 2017, international equities have shined brighter.

Having been reminded of the portfolio benefits of investment style diversification, investors added $120 billion of new money into non-U.S. focused ETFs year-to-date through Sept. 25, more even than the $100 billion put into U.S. products, according to Bloomberg data.

However, the demand for overseas investments has not translated to fixed-income strategies, despite the benefits.

According to Fran Kinniry, a principal in Vanguard’s Investment Strategy Group, the asset manager recommends investors have 30% of their fixed-income assets in non-U.S. investments if availability in tax-qualified plans is ample and the investments are currency-hedged approaches. Yet he notes the average investor has less than 10% in the asset class, and much of it is unhedged.

Kinniry believes the benefit of fixed income is to be the diversifier to the equity risk in a portfolio. If it’s not currency-hedged, the fixed-income asset class becomes high risk and not as powerful.

The firm’s asset allocation strategies hold the Vanguard Total International Stock ETF (VXUS) or Admiral (VTIAX) shares of the hedged Vanguard Total International Bond ETF (BNDX).

BNDX holds government and corporate bonds issued in developed markets, including France, Germany, Japan and the U.K. But the fund protects against a sell-off in the euro, yen and pound with forward contracts.

BNDX Vs BWX

The ETF share class BNDX and Admiral mutual fund class VTABX have a 0.12% expense ratio. Relative to their ETF and mutual fund peers, BNDX has a significantly lower three-year standard deviation of 2.9.

For example, the SPDR Bloomberg Barclays International Treasury Bond ETF (BWX), which invests in similar developed-market bonds without employing hedging, has a three-year standard deviation of 7.5; the international income mutual fund peer average has an average 6.22 standard deviation.

However, the hedging has not helped recent performance, as BWX’s 9.6% year-to-date return as of Sept. 22 has significantly exceeded the 1.3% gain for BNDX.

While ETFs hold only a small portion of the money invested in fixed-income securities, this year’s flow trends are consistent with the U.S.-centric approach.

Year-to-date through Sept. 25, U.S. fixed-income ETFs gathered $89 billion, more than seven times the $12 billion for international fixed-income products. Only one of the 10 most popular fixed-income ETFs this year offers targeted international exposure.

 

Source: Bloomberg, 9/25/2017

 

 

BNDX pulled in $2 billion of the money in 2017, second only to the $3.2 billion that flowed into the iShares JP Morgan USD Emerging Markets Bond ETF (EMB).

The iShares product holds dollar-denominated bonds and, like BNDX, does not seek to minimize the fluctuations of local currencies as they swing higher or lower.

This contrasts with some other popular emerging market fixed-income products such as the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC).

Key Differences

Yet there are notable differences between BNDX and EMB. BNDX’s bond holdings are all investment-grade-rated. EMB has approximately half of its assets in bonds rated BB or below. Large issuers for EMB include Argentina, Columbia, Russia and Turkey, and its 4.4% 30-day SEC yield is significantly higher than BNDX’s 0.74%.

Vanguard also offers the Vanguard Emerging Markets Government Bond ETF (VWOB) and mutual fund (VGAVX) share classes of a dollar-denominated emerging market fund. The ETF has a 0.32% expense ratio, lower than EMB’s 0.39%.

However, there are additional distinctions between them. For example, 16% of VWOB’s assets are in bonds issued in China, more than quadruple the country exposure in EMB.

Vanguard’s Kinniry explained that the firm’s investment strategy group did not use emerging market fixed-income funds in their models, as the primary role of bonds in the portfolio is to truncate equity risk.

For example, the Vanguard LifeStrategy Moderate Growth Fund, which has 60% of its assets in stocks and 40% in bonds, holds only four index mutual funds and not one of VWOB’s mutual fund shares.

CFRA reports on these mutual funds, and ETFs can be found on this platform.

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at cservices@cfraresearch.com. Follow him at @ToddCFRA.

 

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