The Power Of An Int'l Bond ETF Like ‘BNDX’

Investors have been heading back into big aggregate bond ETFs after a bit of a yield scare in the past month that led to losses and redemptions from bond funds.

The scare receded. After all, the economic recovery since the market crash almost seven years ago has been slow, which means rates, apart from a few bumps along the way, are also likely to rise slowly. But the underlying question of what to do when borrowing rates really start trending higher in the U.S. remains very much in focus.

Investors for now are returning to the bond market, plowing assets into broad-market funds, such as the $27 billion Vanguard Total Bond Market ETF (BND |A-94) and the $24 billion Shares Core U.S. Aggregate Bond ETF (AGG | A-98), according to the data we crunch here at ETF.com.

Owning bond funds like BND and AGG seems safe for now as the Federal Reserve this week basically said it won’t begin raising rates at its June meeting as some had thought was possible. Central banks in Europe and Japan are still very much engaged in quantitative easing (QE).

But in the U.S., the expansion of QE ended last year, and the Fed’s first rate hike looks possible at either of the central bank’s September or December meetings. In other words, what are holders of ETFs such as BND or AGG going to do when rates start pushing higher, sending bond prices down?

Going International

One interesting idea I’ve heard lately is that going forward, it might make sense for U.S. investors to get their core bond exposure outside of the U.S. That’s because borrowing rates outside the U.S. are likely to remain low long after the Fed starts tightening borrowing rates.

The European Central Bank has committed to QE through September 2016; there’s no guessing where the Bank of Japan might stop with its ongoing QE, and even the Bank of England may reinstitute some form of QE given fresh evidence that deflationary pressures are posing risks to the U.K. economy.

In practice, that would mean owning an international bond fund like the Vanguard Total International Bond ETF (BNDX | B-57). BNDX is currency-hedged, meaning U.S. investors who own it don’t need to worry about the ways that the dollar’s strength against many currencies these days might kill their returns.

To be sure, it’s easier said than done to shift large amounts of assets from one fund to another given the potential capital gains taxes that could result from the liquidation of a long-held and profitable position.

But in retirement accounts like IRAs, there would be no tax consequences from such a move. So, if BND starts heading lower as the Fed’s first rate hike starts coming into sharper focus, switching to BNDX would make sense.

The price chart below illustrates how owning BNDX instead BND of AGG might be advantageous as that day approaches. It’s a total-return chart that integrates capital gains and yield payments. But those returns are not net of fees and, crucially, aren’t “real” as in adjusted for inflation.

Why BNDX Is Outperforming

BNDX, while clearly subject to the same forces as BND and AGG, has been pulling away from the two U.S.-focused funds in the past year.

Much of that move is in BNDX’s price, as investors piled into the fund with conviction that the lack of inflation in Europe and Japan made owning bonds quite safe. BNDX’s yield to maturity is a paltry 0.95 percent compared with 1.92 percent for BND and slightly more than 2 percent for AGG.

But in the U.S., even though 10-year yields have fallen in the past year, the shorter end of the yield curve is telling the tale of a market slowly coming to grips with the fact that the Fed’s first rate hike is slowly but surely morphing from abstraction to a real possibility.

The chart below of the Treasury yields clearly illustrates this. Ten-year yields are in red; seven-year yields are in blue; three-year yields are in green; and one-year yields are in black.

Charts courtesy StockCharts.com

The Takeaway

So, going back up to the chart that shows returns in the past year, it makes sense to peel out inflation rates from BND and AGG returns, which mean lower “real” returns than the chart shows. But given the dearth of inflation in Europe and Japan, and the fact that about 70 percent of BNDX is in European and Japanese bonds, BNDX’s return in the past year isn’t too far off the 5.28 percent shown in the chart.

To be fair, the Fed hasn’t yet been able to create the 2 percent inflation rate it wants to see before it starts raising rates, but it is slowly getting there. The Fed’s preferred inflation measure is personal consumption expenditures (PCE), and the “core” PCE reading, excluding volatile energy and food, is now at 1.3 percent.

So, there is inflation in the U.S., while in Europe and Japan, inflation is nowhere to be seen. Moreover, QE in Europe and Japan will provide tail winds to bond investors in funds like BNDX. In other words, the trends in the price chart above look likely to continue and perhaps become more pronounced as the first Fed rate hike nears.

There are plenty of fairly complex yield replacement strategies circulating in ETF-land these days, but this one involving replacing exposure to funds like BND or AGG for BNDX seems straightforward and relatively simple to carry out for investors not facing any tax consequences.

At the time this article was written, the author held no positions in the securities mentioned. Contact Olly Ludwig at [email protected] or follow him on Twitter @OllyLudwig.