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A Low-Cost, Currency-Hedged International-Bond ETF

By hedging currency exposure, this fund greatly reduces volatility that plagues traditional international-bond funds.

Thomas Boccellari, 07/04/2014

While investing in international-bond funds can help diversify credit and interest-rate risk, high fees and currency risk can diminish their appeal. Vanguard Total International Bond ETF BNDX attempts to address these problems.

This fund offers diversified, currency-hedged exposure to foreign investment-grade government, corporate, and securitized bonds for a low 0.20% annual fee. It may be a suitable core holding for investors looking to diversify their bond holdings outside the United States.

The fund uses one-month forward contracts to hedge its currency exposure. Currency hedging can protect the fund from a strengthening dollar, but it can also detract from returns when the dollar is weakening. Regardless of how currency fluctuations unfold, currency hedging can help significantly reduce volatility.

While most unhedged international-bond funds have historically exhibited low correlation (0.40) to the Barclays U.S. Aggregate Bond Index over the past 10 years, this is primarily due to currency volatility. In contrast, the currency-hedged Barclays Global Aggregate ex USD Bond Index has higher, though still moderate, correlation (0.75) to that U.S. benchmark.

Over the past decade, the fund's benchmark exhibited comparable volatility to the Barclays U.S. Aggregate Bond Index. However, the fund's current yield-to-maturity (1.7%) is below that of the Barclays U.S. Aggregate Bond Index (2.0%). Its duration (seven years) is also higher than the Barclays U.S. Aggregate Bond Index's (five years), introducing greater interest-rate risk, which could hurt returns if rates rise. Additionally, the average credit rating of the fund's holdings (A) is slightly lower than that of the Barclays U.S. Aggregate Bond Index (AA), which skews heavily toward U.S. Treasuries. However, the diversification benefits that international bonds can offer, coupled with the fund's low fees and hedged currency exposure, could make this a worthy addition to a U.S.-heavy portfolio.

Fundamental View
Because the fund weights its holdings by float-adjusted market cap, the most heavily indebted issuers receive the largest weightings in the portfolio. This weighting approach could increase credit risk because the issuers with the heaviest debt burdens may be the most susceptible to ratings downgrades. However, the fund's focus on investment-grade issuers helps mitigate some of this credit risk. Japan, which represents the fund's largest country weighting (22%), has the largest debt/GDP ratio (more than 200) of any developed country. The Japanese government currently has a long-term S&P and Fitch credit rating average of AA-. However, these agencies have a negative outlook on the Japanese government, which sports a lower short-term credit rating (A+). While the chance of default is very low, a downgrade could cause a drop in bond prices, which could hurt the fund.

Shinzo Abe, Japan's prime minister, and his newly appointed Bank of Japan governor, Haruhiko Kuroda, have put a plan into action that would double the monetary base in an effort to hit an inflation target of 2%. Intended knock-on effects include rising asset prices, increased consumer and business spending, and a weaker yen. While the plan has been well-received and capital expenditures have been trending up, Japan still faces structural challenges, including an aging and thrifty population, which could hamper the country's turnaround.

The fund also has significant exposure (18%) to government bonds issued in Europe. While economic conditions across the European Union have improved over the past few years, more than a fourth of the portfolio is invested in relatively weak countries, including France, Italy, and Spain.

is an ETF Analyst with Morningstar.

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