Finding The Right Int'l Bond ETF

Is there a sweet spot for fixed-income diversification?

Yesterday I highlighted three funds I thought might help out most investor portfolios. One of the ones I highlighted was the Vanguard Total International Bond ETF (BNDX | B-57). I immediately got emails asking about alternatives, risks and emerging markets. So here's a deeper dive into the space.

First off, what's the actual point of adding international bonds to your portfolio? The answer is simple: diversification. I think investors all too often get so caught up in chasing what they think is going to be hot next year, that they forget the fundamental premises of modern portfolio theory: You want to own assets that aren't correlated, so that when one zigs, the other—hopefully—zags. Combining non-alike assets is a surefire winner for long-term risk management.

International bonds fit the bill in spades. Consider how the market stacks up in just one corner of the bond market—corporates:

These are all based on the BofA Merrill Lynch series, so it's about as apples-to-apples as you can get in the topsy-turvy world of bond indexing. That top line is the whole reason people reach for bonds at all—the U.S. investment-grade market has just a 0.09 correlation to the S&P 500.

That's about as diversified as you can get. But look at what you can get out there in the broader marketplace: negative correlations to the U.S. bond market, and in the case of emerging markets, some pretty juicy yields.

So what are your options in ETFs?

To come up with my truly international list, I excluded global funds, like the iShares Global High Yield Corporate Bond (GHYG | B), on the basis that it was heavily invested in the U.S. I also excluded "go anywhere" funds, like the PIMCO Total Return ETF (BOND | B), because of their "core" status in most investors' minds.

What you're left with is a pretty short list—some 40 ETFs covering international bonds of all kinds, and half of those are focused exclusively on emerging markets.

Here are the top 10:

Given both the yield and the correlation benefits, it's no surprise to see emerging markets taking six out of the top 10 slots. And at least this year, investors have been extremely well rewarded for stepping outside the U.S. for their bond exposure:

The clear leader has been the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY | B-60). PCY makes two interesting choices: The first is that it only holds dollar-denominated debt. While large countries generally issue debt in their own currencies, smaller countries often issue U.S. dollar debt in order to attract a broader range of investors, and to allay fears that their bonds will become less valuable simply because their currency goes into free fall.

The second interesting choice is that PCY's index methodology naturally selects liquid bonds (maximum of three) from each country that are considered cheapest to their respective yield curves. In addition, the index equally weights across countries, resulting in roughly equal weights among the debt of 23 countries, from Hungary to the Philippines.

Those choices have really paid off, making it the clear leader in the segment, and significantly outperforming the broad and mostly developed-market approach of BNDX.

Important Caveats

There are a few caveats here, however. The first applies generally to all international bonds. Things like duration are measured intracountry. In other words, when you see a duration reading of five for a Hungarian bond, it suggests that the value of that bond is likely to move by 5 percent for every 1 percent move in the local Hungarian interest-rate curve. This may or may not have any connection to what happens with U.S. interest rates or the rest of your portfolio.

The second issue is going to be measured fund by fund, and that's currency risk. In the case of PCY, you don't have to worry about it, because everything is denominated in dollars. However, there are funds that specifically do leave you exposed to local currencies, such as the Market Vectors Emerging Markets Local Currency Bond ETF (EMLC | B-54).

And last, and perhaps most important, is credit risk. Whole countries have in fact defaulted on their bonds, and it's shockingly common. Argentina is perhaps the most recent example. Even the United Kingdom defaulted on gilts in 1932.

For emerging market countries, issuing dollar-denominated debt may seem like a great idea. But the stronger the dollar gets, the harder it is for those countries to actually service that debt, and any devaluation of their own currencies for other reasons increases the probability of default.

Those risks aren't lost on bond investors, and funds like PCY have had some pretty rough periods. Just look at what happened in 2013:

In a 30-day window, PCY holders had to stomach a 15 percent drop in value as the entire bond market wrestled with the prospect of higher rates and declining purchases by the Federal Reserve.

In other words, don't be coddled by the idea that bonds are somehow "safe" or "low volatility" when you step outside your nice comfortable U.S. shoes.

There is tremendous diversification value in international bonds, but you need to be cognizant of the risks.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.