Looking Toward Non US Bonds

August 27, 2014

Is the time—and interest—coming or going for non-U.S. fixed-income ETFs?

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 Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

Heading into 2014, all the talk was of a higher interest-rate environment here in the U.S. The 10-year Treasury note climbed to 3 percent, everyone was proclaiming that the end of the bull market in bonds was near, and numerous market participants had shortened duration of their bond portfolios.

Fast-forward to nearly eight months later and higher rates look like a distant memory. The 10-year note has rather steadily declined all year and is now trading around the 2.4 percent level. The higher-rates camp has quieted—at least for now.

We’ve also seen a sharp divergence in the normal market-risk pattern. While rates have steadily declined, risk assets have also traded stronger for most of the period. The S&P 500 Index is up nearly 8 percent and is just shy of the 2000 level. After a bit of volatility in July, high-yield spreads have since retreated.

All this said, the argument now could be, “Who’s right—bonds or equities?” History has proven bonds usually lead, which could be a bad sign for risk assets as we head into the last four months of the year.

However, taking the opposite view, which would hold that the rise in risk assets is sensible and that bond yields may again trade higher, how could an investor look to protect against this move? The first answer—shorter-duration and higher-spread fixed income, is a position that has already been put on by investors after the last rate rise. Flows data suggest that many participants are still hewing to this defensive end-of-2013 positioning.

So if the positioning question from above has partially been answered, what other portfolio changes might make sense if rates are about to start trending higher?

Further protection—and diversification—may be in the form of non-U.S. fixed-income ETFs, and there are a number of factors to consider in determining which allocations might be best for your portfolio.

Underlying Risk

In the U.S. bond space, the allocation decision takes into account risk determinants such as duration and credit risk. Investors have similar, though not identical, considerations in non-U.S. bond markets.

In the U.S., it’s become very easy to fine-tune the duration exposure of a portfolio via the different ETFs available, from short-, intermediate- and long-dated ETFs, to even more fine-tuning via the target-maturity options available via the Guggenheim Bulletshares and iShares iBonds products.

But in the non-U.S. bond space, there are fewer options available for duration-tuning. While the underlying exposure of the ETFs may vary in duration based on the index or on active management, State Street Global Advisors and iShares both have broad- and short-duration (one- to three-year) international Treasury ETFs available. Emerging Global Advisors meanwhile has a suite of short-, intermediate- and long-dated emerging market debt funds.

The credit risk question can also be addressed in the non-U.S. space, but similar to the duration question, fewer ETF options exist.

There are a handful of non-U.S. corporate bond ETFs—both investment-grade and high-yield options available. Those include:



Similar to the question that investors ask themselves on the equity allocation side, a non-U.S. fixed-income investor must also decide on location in which to invest. This may come in the form of developed versus emerging markets, regional exposure, or even country exposure.

The developed versus emerging question is rather easily answered in the ETF space. While some of the aforementioned names cover the developed side of the equation, emerging market exposure is also readily accessed via ETFs.

The behemoth in the space is the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB | B-41), which offers exposure to sovereign debt of the emerging nations. But like in the U.S. and developed markets, an investor can branch out to both investment-grade and high-yield corporate exposure in the emerging space. Funds such as the WisdomTree Emerging Markets Corporate Bond Fund (EMCB | B) and the Market Vectors Emerging Markets High Yield Bond ETF (HYEM | B) make such fine-tuned allocations a reality.

However, the regional- and country-exposure question gets a little trickier.

There have been successful launches in the past few years, notably the WisdomTree Asia Local Debt Fund (ALD | C) and the PowerShares Chinese Yuan Dim Sum Bond Portfolio (DSUM | B). However, the lack of interest in such granular exposure has become evident. Late in 2013, Market Vectors switched its Latin America Aggregate product over to a broad emerging markets aggregate fund.

Additionally, Pimco just announced the shuttering of its suite of country-exposure bond ETFs:

So, the takeaway is that investor demand isn’t fully there yet.


Another factor that must be taken into consideration when investing in the non-U.S. space is currency exposure. Specifically, investors now have more and more opportunities in the ETF world to decide whether they want their currency exposure hedge. On the equity side, this concept has taken off with the proliferation of currency-hedged products.

However, this has not taken yet hold in the fixed-income space.

In emerging markets, rather than hedged versus non-hedged, an advisor can choose from dollar or nondollar-denominated debt. This partially answers the currency question, but the big difference here is the underlying exposure is quite different between a dollar- and nondollar-denominated product.

As the countries that have the ability to issue local versus dollar denominated varies, so will the underlying exposure and quality.

Here’s a quick side-by-side comparison of three local currency emerging market debt ETFs versus that of the dollar-denominated iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB | B-41), with top 10 country exposure noted:


Duration 4.3 4.8 4.8 7.3
Yield 5.6 6.2 5.7 4.9
Rating BBB+ BBB+ BBB+ BBB-
. .
South Korea 23.50 Poland 10.53 Brazil 14.33 Turkey 5.73
Brazil 17.51 South Africa 9.50 South Korea 13.80 Brazil 5.44
Thailand 4.89 Malaysia 8.79 Poland 7.49 Indonesia 5.44
South Africa 4.89 Turkey 8.23 Malaysia 6.59 Philippines 5.40
Malaysia 4.87 Russia 6.95 Thailand 5.05 Russia 4.88
Colombia 4.83 Mexico 6.54 South Africa 5.03 Colombia 4.58
Russia 4.79 Indonesia 6.45 Colombia 4.97 China 4.34
Indonesia 4.79 Brazil 6.25 Indonesia 4.94 Hungary 4.09
Israel 4.76 Thailand 6.10 Israel 4.93 Venezuela 3.90
Turkey 4.60 Colombia 5.87 Turkey 4.90 Poland 3.74

A few notes of difference:

  • Duration of the local-currency ETFs is much shorter than that of the dollar-denominated because of the issuer’s ability to use, and investor interest in, longer-term debt in non-USD form
  • The local currency average rating is higher because of the higher stability needed for the country to be able to issue and to attract investors for non-USD debt
  • The yield is higher because market rates are determined locally versus being “pegged” to the U.S. curve in the USD-denominated bonds
  • The local currency ETFs have more single-country risk based on size of country/issuance in the local currency

Stepping back to the developed side, there is a lack of currency-hedged products available. The largest in the space is the Vanguard Total International Bond ETF (BNDX | B-53), which tracks the broad non-U.S. aggregate bond index. Also, Pimco recently announced the launch of an actively managed dollar-hedged product, the Pimco Foreign Bond Active ETF.

While the currency exposure can have a diversifying effect comparing a U.S. versus a hedged non-U.S. portfolio, it can also lead to greater volatility.

Here’s a quick year-to-date example using the Global Aggregate ex-USD Float Adjusted RIC Capped Index, the benchmark that underlies Vanguard’s BNDX. We’ll look at it on an unhedged (BGRCTRUU) and hedged (BGRCTRUH) basis. Also, I’ve compared those two versions of the index with the Barclays U.S. Aggregate Bond Index (LBUSTRUU).



A few observations about this comparison:

  • The hedged non-U.S. Aggregate has outperformed the unhedged version by nearly 1.6 percentage points this year due to the weakness of the euro, particularly over the past four months.
  • The unhedged non-U.S. index has performed similarly to the U.S. Aggregate, but with greater volatility due to currency fluctuations.
  • The hedged non-U.S. has outperformed the U.S. Aggregate by nearly 1.4 percentage points year-to-date, with the outperformance coming in the past three months.


As with building a diversified equity portfolio, there are numerous decisions that need to be made when building out a diversified fixed-income portfolio.

While the suite of non-U.S. ETFs is not as robust as on the U.S. side, there are numerous differentiated funds available to use in building a diversified fixed-income portfolio.

Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-636 or www.stadionmoney.com. References to specific securities or market indexes are not intended as specific investment advice.


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