Don’t Assume US Bond ETFs Are US Focused

July 16, 2014

If you think U.S.-focused bond ETFs are chock full of U.S. bonds, it’s time to think again.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Scott Kubie, chief investment strategist of Omaha, Neb.-based CLS Investments.

How much international exposure should you have in your portfolio? Most of the time the person who asks this question is referring to their stock allocation. But what about other parts of the allocation?

Rarely does anyone ask about their corporate bond allocation. If they did, they might discover they owned a lot more international bonds than anticipated. There are some ways to address this challenge, but suffice it to say it’s not a problem investors have a grip on.

So, let’s get into it, and then look at solutions.

ETFs that invest primarily in corporate bonds often contain large allocations to international bonds.

Table 1 below includes the bond ETFs in the U.S. classified by Morningstar as corporate bond, short-term bond or ultrashort bond with at least $100 million in assets.

It’s clear there’s a high degree of variability between bonds in the same category, but the international allocations are significant in most cases.


For corporate bonds, two funds based on the Barclays U.S. Credit Index—the iShares Intermediate Credit Bond ETF (CIU | B-88) and the iShares Core U.S. Credit Bond ETF (CRED | B-89)—include an allocation to international bonds of about 30 percent.

The iShares iBoxx $ Investment Grade Corporate Bond (LQD | A-75) is close to 20 percent. Short-term bonds are in the same position. For example, the iShares 1-3 year Credit Bond ETF (CSJ | B-91) is 43 percent non-U.S. bonds, and most short-term and ultrashort ETFs allocate more than 20 percent to international bonds.


Potential Portfolio Challenges

There are three key portfolio design challenges that come from the heavy use of international bonds in domestic corporate bond ETFs.

First, investors using international bonds in their portfolios may end up with a higher exposure than desired. Second, a decision to overweight corporate bonds, relative to Treasurys, increases the international-bond allocation. Third, some of the ETFs have country allocations that represent a major departure from international bond indexes.

The first challenge is that the international bonds embedded in the funds in Table 1 represent an exposure to an asset class that is greater than many investors care to own.

As demonstrated in the “Allocation 1” table below, a moderately conservative asset allocation may put 60 percent in bonds, 48 percent in a broad U.S. aggregate bond ETF, and 12 percent in a targeted international bond.

Allocation 1
Fund Allocation % % Intl Bond Intl Bond Exposure
International Bond 12% 100% 12%
Total Bond Market (US Index) 48% 7% 3%
Allocation 1 Bond Portfolio 60% 15%

These sample allocations are meant to serve as examples. Actual holdings may differ.

In addition to the explicit 12 percent allocation, the portfolio picks up another 3 percent from the 48 percent allocation to a total bond market index fund. That gives the client a total of 15 percent allocated to international bonds, rather than the desired 12 percent allocation.

Of even greater concern is that the decision to overweight corporate bonds naturally increases the international bond allocation.

Since the Federal Reserve has purchased such a large portion of the low-yield Treasurys, many investors have lost interest in this asset class. Some investors are seeking to maintain income in a low-rate environment, and are using corporate bonds to boost the yield of their portfolios.

When investors use bond ETFs for this purpose, “Table 1” at the outset shows they’re purchasing sizable chunks of international bonds at the same time they’re reducing the 100 percent U.S. allocated Treasurys and mortgages included in U.S. total bond market ETFs.

If a client should choose to adjust the allocation toward U.S. credit by combining all the bonds into the iShares U.S. Credit Bond ETF (CRED) mentioned earlier, they would actually have increased their international bond allocation to 18 percent, as displayed in the “Allocation 2” table below. While the portfolio has a greater exposure to corporate bonds, the allocation to international bonds is 18 percent and increases by 3 percentage points over the more diversified portfolio.



Allocation 2 And Comparison To Allocation 1
Fund Allocation % % Intl Bond Intl Bond Exposure
iSharse US Credit Bond ETF 60% 30% 18%
Allocation 2 Bond Portfolio 60% 30% 18%
Allocation 1 Bond Portfolio 60% 15%

These sample allocations are meant to serve as examples. Actual holdings may differ.

Some of the ETFs and indexes include “U.S.” in their title, so it may be very easy for investors to overlook the shift in their country allocation that is occurring.

Many investors may assume selling the iShares 1-3 Year Treasury Bond ETF (SHY | A-97) and buying an ETF that tracks the Barclays U.S. 1-3 Year Credit Bond Index (CSJ) we mentioned above involves very little change in the country allocation. Instead, more than 40 percent of the assets in CSJ are backed by firms outside the U.S.

The debt included in the ETFs above is often dollar-denominated, but it depends on the ETF. One risk for financial planners is that investors will discover their international bond allocation is much greater than they expected or desired. An international corporate bankruptcy or the sudden decline in the euro may show up directly in the price of these ETFs.

The third allocation challenge is that some of the active ETFs can take on large allocations to specific countries. The Pimco Low Duration ETF currently has a 12 percent allocation to South Korean bonds.

That makes South Korea the second-largest country allocation after the United States. That seems like a large allocation for a country that only makes up 2.02 percent of the Vanguard Total International Bond Index Fund (BNDX | B-46).

Users of the actively managed funds will have to pay attention to expected country allocations and anticipate that weights will change with opportunities.


Are there any potential solutions?

The PowerShares Fundamental Investment Grade Bond Portfolio (PFIG | B-75) offers the best alternative to the international bond allocation challenge. As part of its index design, the $26 million ETF excludes foreign agencies, governments and supranationals.

All issuers must be domiciled in the United States. (Table 1 shows Morningstar identifies only 1.26 percent of the bonds as outside the U.S., most likely due to differences in the classification of a small number of issuers.)

While the main selling point of PFIG is its fundamental weighting methodology, it also appears to offer the most domestically focused bond available. Hopefully, some of the ETF providers will look at an index that invests in the U.S. only. Until then, I believe PFIG is your best choice for keeping your bond allocation close to home.

CLS Investments is an Omaha, Neb.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Investment Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.

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