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Diversification for the Sake of Diversification

Vanguard's Total International Bond exchange-traded fund is a poor investment today.

Samuel Lee, 08/01/2014

I don’t know why Vanguard bothered to launch Vanguard Total International Bond ETF BNDX, a currency-hedged developed-markets bond fund. When you hedge foreign sovereign bonds, you end up with something that looks a lot like U.S. Treasuries. Vanguard points to some modest historical diversification benefits, but this backward-looking analysis fails to consider how present valuations and economic conditions affect prospective returns and correlations. The fund yields about 1.5% and has a duration of roughly seven years. The Barclays U.S. Aggregate Index, which can be owned through any number of dirt-cheap options, including Vanguard Total Bond Market ETF BND, yields a little more than 2% and has a duration of about five years. The fund seems to be a case of diversification for the sake of diversification.

If you're a diehard efficient-market person, the foreign bond index’s lower yield and higher duration must be compensation for some kind of risk-hedging benefit. Of course, this is crazy when you consider the bonds’ modest diversification benefits, low expected returns, and the fact that their sovereign issuers are more indebted and slower-growing than the United States.

The main reason these bonds trade at such valuations is that financial institutions under the purview of European and Japanese regulators are "encouraged" to own them. If you’re not under the regulators’ thumbs, why act as if you were? In this case, the logic of market-cap weighting breaks down: The individual investor is very different from the typical owner of sovereign bonds.

I can see a role for this fund when interest rates are a lot higher and developed-markets yield curves aren’t so homogeneous. Not today, though.

On the plus side, this fund beats pretty much every other developed-markets foreign-bond fund on fees. Speaking of which, it’s a bit of a mystery why billions of dollars are in this fund’s more-expensive competitors. SPDR Barclays International Treasury Bond BWX charges a sizable 0.50% annual levy and happens to have a similarly risible yield, yet holds a little more than $2.4 billion. The last place you want to pay a rich expense ratio is in ultraexpensive foreign bonds.

Below is an analysis from my colleague Tom Boccellari.

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BNDX offers diversified exposure to foreign investment-grade government, corporate, and securitized bonds. The fund’s broad geographic exposure may help diversify interest-rate and credit risks.

Samuel Lee is an ETF Analyst with Morningstar.

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