What Are They?
- Like International bond mutual funds, International bond ETFs provide exposure to bonds by tracking indexes with fixed duration. In other words, these bond indexes contain bonds with various maturity dates, managed so that the entire index has a fixed average maturity. If projected interest rates rise, the price of a bond ETF falls.
- International and Emerging Market Government bond ETFs contain only non-U.S. Government Treasury bonds. Distributions from International bonds are not exempt from state and local taxes as is the case with distributions from U.S. Treasury funds (but be sure to check with your accountant for precise details). Emerging Market bonds contain a higher risk profile than Developed Market bonds of similar duration. This risk is offset by the considerably higher yields Emerging Market bonds offer.
- International Inflation-protected bonds such as TIPS (Treasury Inflation Protected Securities) pay interest equal to the issuing nation's consumer price index plus a premium. As a result inflation protected bonds tend to outperform regular bonds when projected inflation rises and tend to underperform standard Treasuries during deflationary periods.
Why and How To Use Them
- International bonds ETFs are a core component of a diversified bond portfolio, as they can behave differently to U.S. bond funds and therefore dampen volatility. This diversifying effect is especially true of Emerging Market bond funds.
- In terms of general portfolio building, bonds are considered safer (i.e. less volatile) than stocks and generate interest income, making them particularly suitable for people in or nearing retirement. However, bonds tend to produce lower long-term returns than stocks, so younger investors who can tolerate more short-term volatility often opt for a lower allocation to bonds.
- Developed Market government bonds are safer than their Emerging Market peers and as a result, offer considerably lower yields. Compare for example the current yield (12/2/09) on the iShares S&P/Citi International Treasury Bond ETF (NASDAQ:IGOV) vs. iShares JPMorgan USD Emerging Markets Bond ETF (NYSEARCA:EMB). IGOV currently offers a 30-day SEC yield of 1.93% and a weighted average maturity of 8.46 years. This compares to EMB's 30-day SEC yield of 5.68% and average weighted maturity of 12.26 years. Even taking into account the discrepancy in maturity, EMB's yield is well above IGOV's. IGOV carries an S&P credit rating of AA while EMB caries an S&P credit rating of BB.
- Inflation protected bonds behave differently from other types of bonds (if expected inflation rises, the price of TIPS rises but the price of regular bonds falls), so they should be considered a separate asset class when allocating for them in your portfolio.
- Short-term International bond ETFs can be used as an alternative to money market funds. In many cases, they pay higher rates of interest than brokerages pay on cash. Short-term bond funds pay out a lower yield than longer-term funds except in periods of an inverted yield curve (extremely rare). Such an occurrence is widely considered a predictor of an approaching recession.
- Distributions from International bond ETFs are not exempt from state and local taxes as is the case with U.S. Treasury ETF distributions.
What to Look Out For
- The SPDR Barclays Capital International Treasury Bond ETF (NYSEARCA:BWX) has a considerably higher expense ratio (0.50%) than than the iShares S&P/Citi International Treasury Bond ETF (IGOV) (0.35%). Similarly, the iShares JPMorgan USD Emerging Markets Bond ETF (EMB) has a higher expense ratio (0.60%) than the PowerShares Emerging Markets Sovereign Debt Fund (NYSEARCA:PCY) (0.50%).
- SPDR's International bond funds offer exposure to some Emerging Market debt with the SPDR Barclays Capital International Treasury Bond ETF (BWX) carrying nearly 14% of its holdings in Baa or lower-rated bonds as of Dec. 1, 2009. This compares to the iShares S&P/Citi International Treasury Bond ETF (IGOV) which carries no foreign government debt with a sub-A credit rating. SPDR's International bond funds offer a slightly higher yield than iShares' funds as a result of their inclusion of Emerging Market government bonds in their portfolio of holdings.
- There is a slight discrepancy in ratings applications between the different agencies (Moody's vs. S&P). It is important to understand underlying credit rating differences when analyzing the overall safety profile of a bond ETF.
- Some basic introductions to the various funds listed above - BWX: SSgA's New International Bond ETF Is a Possible Dollar Hedge (IndexUniverse/Heather Bell); BWZ: State Street Challenges BGI with Latest ETFs (IndexUniverse); IGOV/ISHG: Two New International Bond ETFs (Ron Rowland); WIP: First Global TIPS ETF Hits U.S. (IndexUniverse/Murray Coleman); EMB: EMB Brings Choice for Emerging Market Debt ETFs (IndexUniverse/Heather Bell); PCY: PowerShares Emerging Markets Sovereign Debt ETF: Let the Games Begin (James Picerno). For a general overview of International bond ETFs, see Five Pack of Ex-U.S. Treasury Bond Funds (Thomas Smicklas).
- Gary Gordon considers the merits of International bond ETFs in Foreign Bond ETFs: Considering Dollar Devaluation and Maximizing Income Stream. Gordon examines Emerging Market Bond ETFs in Record Inflows Favor Emerging Market Bond ETFs. Scott's Investments has some nice charts mapping out International Bond ETFs' Correlation to Equities.
- For a general discussion about inflation protected bonds, see Why Investors Should Avoid TIP and the discussion in the comments below. For specific comparisons of TIP to WIP, see WIP vs. TIP: Two ETFs to Hedge Inflation (Michael Johnston) and WIP and TIP: Better than Gold (Living4Dividends).
This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.