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The Missing Piece

This currency-hedged international-bond fund offers core exposure to one of the world's largest asset classes, which U.S. investors often overlook. 

Alex Bryan, 12/13/2013

The Barclays US Aggregate Bond Index has become a widely accepted benchmark for investors seeking broad passive exposure to the U.S. investment-grade bond market. But until recently, there were no index funds that offered similar exposure to international bonds. Investors had to assemble this portfolio piecemeal with separate international government- and corporate-bond funds. More problematically, currency fluctuations have a significant impact on most of these funds' returns and volatility, limiting their ability to diversify credit and interest-rate risk. High expense ratios also create a significant drag on their performance. Vanguard International Bond Index ETF BNDX fills this void. For a low 0.20% expense ratio, it offers broad exposure to fixed-rate investment-grade government and corporate debt issued in foreign currencies, with more than one year to maturity. Vanguard attempts to hedge the fund's currency risk. This hedge should make interest-rate, inflation, and credit risk more-important drivers of the fund's performance. The fund could serve as a core holding for cost-conscious investors looking to diversify these risks. It is also available in a mutual fund format.

While it was only launched in May 2013, the fund has already amassed assets amounting to more than $18 billion across all of its share classes. But investors aren't flocking to this fund for its yield. As of the end of October, the fund's holdings had an average yield to maturity of 1.8%, slightly lower than the corresponding figure for the Barclays US Aggregate Float Adjusted Index, 2.2%. That may be partially explained by the fact that it has greater exposure to government bonds, which represent more than three fourths of the portfolio.

Government debt isn't as safe as it used to be. In many parts of the developed world, years of flagrant spending combined with depressed tax revenues resulting from prolonged recessions have led to crushing debt/GDP ratios and sovereign credit rating downgrades. Because it weights its holdings according to the float-adjusted market value of each issue, the fund's holdings tend to skew toward the most heavily indebted issuers, which can increase credit risk. For instance, as of 2012, Japan's public debt exceeded 200% of GDP, the highest ratio of any developed country. This heavy debt load compelled the fund to take a large position in Japanese bonds. Japan faces an aging population and chronically sluggish growth that may continue to pressure the country's public finances. Consequently, S&P and Fitch have both placed a negative outlook on Japanese sovereign debt.

Market-cap weighting is a reasonable approach for a stock index fund because it harnesses the collective wisdom of the market about the relative value of each holding. But applying the same concept to bonds may be less optimal. After all, Japanese government debt is not necessarily more valuable because the government is heavily indebted. However, this weighting approach is easy to replicate and helps keep costs down by tilting the fund toward the most liquid issues. It also accurately reflects the performance of the broad bond market. In order to preserve diversification, the fund limits its exposure to any single issuer to 20% of the portfolio. This limit currently only affects debt issued by the Bank of Japan.  

Because the fund invests only in investment-grade bonds, the risk of an outright default is relatively low. However, deterioration of issuers' credit quality can still hurt its performance. Credit ratings downgrades have plagued the fund's European sovereign debt holdings. In October 2012, S&P downgraded Spanish sovereign debt to BBB- from BBB+ and placed a negative outlook on the country. In the wake of a debt-fueled construction boom, Spain is now plagued with an unemployment rate in excess of 26% that has depressed the government's revenue base and must implement politically unpopular budget cuts to bring its debt down to a sustainable level. Further downgrades could cause Spanish debt to lose its investment-grade status.

In July 2012, Moody's downgraded Italy's sovereign credit rating to Baa2 from A3, citing weak growth, rising unemployment, and contagion risk, which could lead to higher borrowing costs for Italy. S&P and Fitch followed suit with similar downgrades for Italian sovereign debt earlier this year. Even the strongest European sovereign borrowers are not immune. Moody's stripped France and the United Kingdom of their AAA credit ratings in November 2012 and February 2013, respectively.   

The fund also exposes investors to meaningful interest-rate risk. As of the end of October 2013, its average duration was 6.7 years. However, most of the fund's holdings were issued in countries whose central banks may be less likely to raise interest rates in the near term than the Federal Reserve. Bonds issued in the eurozone represent close to 53% of the fund's portfolio. While the region has stabilized, it is struggling with an unemployment rate above 12% and anemic growth. Consequently, the European Central Bank is unlikely to raise interest rates in the near term.

Similarly, the fund's Japanese bonds are unlikely to face rising interest-rate pressure from the Bank of Japan. These holdings account for 23% of the portfolio. The bank's new governor, Haruhiko Kuroda, has commited to an aggressive monetary policy, in which the bank will continue to expand the monetary base to hit a 2% inflation target by the end of 2014. As a result, Japanese interest rates will likely remain ultralow. But an unexpected bump in inflation could erode the fund's returns.    

Alex Bryan is an ETF analyst with Morningstar.

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