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By Thomas Boccellari

While investing in international-bond funds can help diversify credit and interest-rate risk, high fees and currency risk can diminish their appeal. Vanguard Total International Bond ETF (NASDAQ:BNDX) attempts to address these problems.

This fund offers diversified, currency-hedged exposure to foreign investment-grade government, corporate, and securitized bonds for a low 0.20% annual fee. It may be a suitable core holding for investors looking to diversify their bond holdings outside the United States.

The fund uses one-month forward contracts to hedge its currency exposure. Currency hedging can protect the fund from a strengthening dollar, but it can also detract from returns when the dollar is weakening. Regardless of how currency fluctuations unfold, currency hedging can help significantly reduce volatility.

While most unhedged international-bond funds have historically exhibited low correlation (0.40) to the Barclays U.S. Aggregate Bond Index over the past 10 years, this is primarily due to currency volatility. In contrast, the currency-hedged Barclays Global Aggregate ex USD Bond Index has higher, though still moderate, correlation (0.75) to that U.S. benchmark.

Over the past decade, the fund's benchmark exhibited comparable volatility to the Barclays U.S. Aggregate Bond Index. However, the fund's current yield-to-maturity (1.7%) is below that of the Barclays U.S. Aggregate Bond Index (2.0%). Its duration (seven years) is also higher than the Barclays U.S. Aggregate Bond Index's (five years), introducing greater interest-rate risk, which could hurt returns if rates rise. Additionally, the average credit rating of the fund's holdings (A) is slightly lower than that of the Barclays U.S. Aggregate Bond Index (AA), which skews heavily toward U.S. Treasuries. However, the diversification benefits that international bonds can offer, coupled with the fund's low fees and hedged currency exposure, could make this a worthy addition to a U.S.-heavy portfolio.

Fundamental View
Because the fund weights its holdings by float-adjusted market cap, the most heavily indebted issuers receive the largest weightings in the portfolio. This weighting approach could increase credit risk because the issuers with the heaviest debt burdens may be the most susceptible to ratings downgrades. However, the fund's focus on investment-grade issuers helps mitigate some of this credit risk. Japan, which represents the fund's largest country weighting (22%), has the largest debt/GDP ratio (more than 200) of any developed country. The Japanese government currently has a long-term S&P and Fitch credit rating average of AA-. However, these agencies have a negative outlook on the Japanese government, which sports a lower short-term credit rating (A+). While the chance of default is very low, a downgrade could cause a drop in bond prices, which could hurt the fund.

Shinzo Abe, Japan's prime minister, and his newly appointed Bank of Japan governor, Haruhiko Kuroda, have put a plan into action that would double the monetary base in an effort to hit an inflation target of 2%. Intended knock-on effects include rising asset prices, increased consumer and business spending, and a weaker yen. While the plan has been well-received and capital expenditures have been trending up, Japan still faces structural challenges, including an aging and thrifty population, which could hamper the country's turnaround.

The fund also has significant exposure (18%) to government bonds issued in Europe. While economic conditions across the European Union have improved over the past few years, more than a fourth of the portfolio is invested in relatively weak countries, including France, Italy, and Spain.

The European Central Bank recently lowered rates to a record low of 0.15%, while short-term rates in Japan are close to 0.10%. Although interest rates where many of the fund's holdings are invested will likely remain low in the short term, they have little room to fall and plenty of room to rise as economic growth picks up. This could hurt the fund's performance over the long term because bond prices tend to fall as interest rates rise.

While the fund only has a 12-month record, it has done a good job hedging currency exposure over that period. Since the fund's inception, the fund has had minimal tracking error to its benchmark.

Portfolio Construction
The fund employs representative sampling to track the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped (USD Hedged) Index, which includes investment-grade government (75%), corporate (15%), and securitized fixed-income investments (10%) issued in local currency. The bonds must have at least one year until maturity. The index weights its holdings by float-adjusted market capitalization and rebalances at the end of each month. The top three countries in the fund, Japan, France, and Germany, represent nearly 45% of the portfolio. The portfolio has an average duration of 6.8 years and a yield to maturity of 1.7%.

The fund uses one-month forward currency contracts, which it rebalances every month to hedge currency exposure. The fund attempts to adjust its hedges as assets grow or shrink to help minimize over- and underhedging. Underhedging a currency that has weakened relative to the U.S. dollar or overhedging a currency that has strengthened can hurt the fund's performance. While the fund has 23 different currencies represented in its portfolio, more than 90% of the fund's assets are denominated in the pound, euro, yen, Australian dollar, and Canadian dollar. Because these are very liquid currencies, they are relatively inexpensive to hedge. Since inception, hedging has only created a 0.05% drag on performance.

Alternatives
SPDR Barclays International Treasury Bond (BWX) may be a reasonable alternative for investors who want to bet against the U.S. dollar. It invests in foreign government bonds and does not hedge its currency exposure. Consequently, currency fluctuations largely drive its performance. This fund charges 0.50%. iShares offers a similar fund, iShares S&P/Citigroup International Treasury Bond (IGOV), which charges 0.35%. In contrast to BNDX, BWX and IGOV exclude corporate debt.

SPDR DB International Government Inflation-Protected Bond (WIP) may be suitable for investors who are concerned about inflation. It offers an international portfolio of Treasury Inflation-Protected Securities for a 0.50% expense ratio. However, WIP does not hedge its currency exposure, which may reduce the efficacy of its inflation hedge. Additionally, it invests only in government debt.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: A Low-Cost, Currency-Hedged International-Bond ETF