Although corresponding to roughly a quarter of the value of global securities markets, international bonds get short shrift in U.S.-based institutional and retail investment portfolios. The same holds true in the burgeoning market for exchange-traded funds offering exposure to international fixed-income securities.
The Vanguard Group, the latest ETF sponsor to offer international fixed-income, could help reverse such limited use.
For a period after the financial crisis, several ETFs offering primarily unhedged exposure to both developed and emerging markets bonds attracted significant assets, offering both high yields as well as equity-like returns (and volatility) due to currency shifts. According to Markit ETP Analytics, the category grew to nine fund by the end of 2009 from three in 2007. Net flows went to $3 billion from just more than $200 million. Separate funds launched in late 2007 by iShares and PowerShares offering dollar-denominated emerging markets debt amassed $5 billion and $2 billion, respectively, as liquidity grew and spreads narrowed significantly.
A broad-based international treasury ETF from State Street, also launched in late 2007, has grown to nearly $2 billion in assets.
Not dissimilar to the development of the market for U.S.-based government and corporate fixed-income ETFs a decade ago, more extensive developed and emerging markets bond ETF offerings have been launched in the past three years. Investors can now choose from global and regional sovereign bonds, investment-grade and high-yield corporates, and target-maturity ETFs. Total assets are approaching $25 billion.
Of the nearly 60 ETFs and exchange-traded notes offering exposure to international fixed income, each fund is generally offered at an expense ratio of 35 to 65 basis points. Comparatively, 97 of all 237 U.S.-listed fixed-income ETFs are managed for 15 basis points or less, according to XTF Inc., New York.
Vanguard's international fixed-income index ETFs come as signs of an interest rate reversal rout are beginning to wear away the value of intermediate- and long-duration bond portfolios. In such an environment, fund costs are magnified.
“Vanguard will challenge investors on how much they are willing to pay for exposure to these assets,” said Todd Rosenbluth, director of ETF research, for S&P Capital IQ in New York. Throughout 2012, for example, several ETF sponsors in the U.S. reduced expense ratios on equity funds amid aggressive competition for assets and even talk of a “price war.”
Of 179 institutional investors surveyed by Greenwich Associates this spring, 68% listed expense ratio among the three most important aspects when evaluating an ETF. Only liquidity/trading volume was higher at 76%.
The Vanguard Emerging Market Government Bond ETF, tracking the Barclays USD Emerging Markets Government RIC Capped index, has a 35-basis-point expense ratio, compared with 59 basis points for the $4.9 billion iShares JPMorgan USD Emerging Markets Bond Fund and 50 basis points for the $2.2 billion PowerShares Emerging Markets Sovereign Fund. Only a 40-basis-point corporate high-yield emerging markets fund from Van Eck Global approaches the Vanguard fund's cost.
The Vanguard Total International Bond ETF, based on the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped USD Hedged index, costs 20 basis points.
Through Vanguard's patented structure whereby ETFs exist as share classes of traditional funds, the fund already has landed significant assets. In February, the company announced that 20% of the fixed-income allocation across its all-in-one funds would be shifted to Total International Bond. These funds collectively hold more than $150 billion in assets and include life strategy funds, managed payout funds and target retirement funds.
So, while the ETF share class represents only about $30 million in net asset value, the entire fund holds more than $14 billion in assets.
Pension and endowment investors, however, may take little notice as very few have stepped up as holders of international bonds, let alone ETFs or indexed assets, according to Pensions & Investments data. And, according to the Greenwich Associates survey, international fixed-income ETFs were used sparingly by both institutional funds (13% of respondents) and investment consultants (19%) compared to far wider use of equities and even domestic fixed income (36% and 38%, respectively).
“Often large institutions want to do their own hedging,” said Joel Dickson, investment strategist at Vanguard in Malvern, Pa. Hedging for the Total International Bond Fund is based upon the index's mandated one-month forward hedge (month-end) for the aggregate currency exposure across all bonds. Eighty percent of the fixed-income securities in the underlying index are denominated in euros, yen or British pounds.
“Historically, volatility of the currency movements has swamped international fixed income,” said Mr. Dickson, citing 2012 Vanguard research detailing that nearly two-thirds of the volatility in fixed income is due to currency fluctuation as opposed to security prices. For international stocks, the vast majority of volatility is due to the security, not the currency.
Unlike much of the ETF universe, where index funds rule, actively managed ETFs account for $8.1 billion of the $24.6 billion invested in international fixed-income ETFs, according to Markit. Separately, 50% of the funds are focused on emerging markets and 50% hold only government issues.
When evaluating the nearly 60 exchange-traded products offering international fixed-income exposure, Markit's Christos Costandinides, director of index research in London, suggests that investors first look at the underlying holdings to get a sense of the reliability of the pricing. “This is primarily an issue for less-liquid, high yield securities,” he said.
Mr. Costandinides did point out that greater liquidity and assets in the ETFs could significantly benefit intraday price discovery for less-liquid international securities, as has been observed for corporate debt and senior loans in the U.S.
For index-based products, investors would also need to look at index construction, the methodology and the holdings of the ETF relative to the index. Unlike most equity-index products, fixed-income funds tend to approximate the exposure of the index through sampling. The over-the-counter fixed-income market generally prevents full replication.
A true final frontier for international fixed-income ETFs could be single-country funds, but Matt Tucker, fixed-income strategist for the iShares unit of BlackRock, does not see this trend landing anytime soon.
“In fixed income, most local markets are dominated by a sovereign issuer, making (the) diversification, required for a "40 Act fund, difficult to obtain,” said Mr. Tucker in San Francisco. “There often isn't enough supply or liquidity in non-sovereign issuers in a given market to meet the diversification requirement.”
As for the diversification value that international fixed income can bring to a portfolio, the jury is still out. Because fixed-income securities tend to be unified by globally applied credit rating standards and spreads to the (assumed) risk-free asset of similar duration, distinctions such as “emerging” or “developed” can easily wash away.
