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By Samuel Lee and Thomas Boccellari

I don’t know why Vanguard bothered to launch Vanguard Total International Bond ETF (NASDAQ:BNDX), a currency-hedged developed-markets bond fund. When you hedge foreign sovereign bonds, you end up with something that looks a lot like U.S. Treasuries. Vanguard points to some modest historical diversification benefits, but this backward-looking analysis fails to consider how present valuations and economic conditions affect prospective returns and correlations. The fund yields about 1.5% and has a duration of roughly seven years. The Barclays U.S. Aggregate Index, which can be owned through any number of dirt-cheap options, including Vanguard Total Bond Market ETF (NYSEARCA:BND), yields a little more than 2% and has a duration of about five years. The fund seems to be a case of diversification for the sake of diversification.

If you're a diehard efficient-market person, the foreign bond index’s lower yield and higher duration must be compensation for some kind of risk-hedging benefit. Of course, this is crazy when you consider the bonds’ modest diversification benefits, low expected returns, and the fact that their sovereign issuers are more indebted and slower-growing than the United States.

The main reason these bonds trade at such valuations is that financial institutions under the purview of European and Japanese regulators are "encouraged" to own them. If you’re not under the regulators’ thumbs, why act as if you were? In this case, the logic of market-cap weighting breaks down: The individual investor is very different from the typical owner of sovereign bonds.

I can see a role for this fund when interest rates are a lot higher and developed-markets yield curves aren’t so homogeneous. Not today, though.

On the plus side, this fund beats pretty much every other developed-markets foreign-bond fund on fees. Speaking of which, it’s a bit of a mystery why billions of dollars are in this fund’s more-expensive competitors. SPDR Barclays International Treasury Bond (NYSEARCA:BWX) charges a sizable 0.50% annual levy and happens to have a similarly risible yield, yet holds a little more than $2.4 billion. The last place you want to pay a rich expense ratio is in ultraexpensive foreign bonds.

Below is an analysis from my colleague Tom Boccellari.

BNDX offers diversified exposure to foreign investment-grade government, corporate, and securitized bonds. The fund’s broad geographic exposure may help diversify interest-rate and credit risks.

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 fund uses one-month forward currency contracts, rebalanced monthly, to hedge currency exposure. The fund attempts to adjust its hedges as assets grow or shrink to minimize over- and underhedging. While the fund has 23 different currencies represented in its portfolio, the top five currencies--the pound, euro, yen, Australian dollar, and Canadian dollar--represent more than 90% of the fund’s total assets. Because most of the assets are low-yielding and liquid, hedging costs are minimal.

The fund’s market-cap-weighting means the most indebted issuers receive the largest weightings in the portfolio. Japan, the fund’s largest weighting at around 22%, has a debt/GDP ratio over 200%, higher than any other developed country’s. While the Japanese government currently has a long-term S&P and Fitch credit rating average of AA-, the outlook is negative.

Japan is interesting because Prime Minister Shinzo Abe has set into motion a Manhattan Projectlike "three-arrow" plan of ultraloose monetary policy, fiscal stimulus, and structural reforms to cure the country of deflation and economic sclerosis. The first two arrows were loosed soon after he was elected in December 2012. He announced a JPY 10.3 trillion stimulus and appointed ultra-dove Haruhiko Kuroda governor of the Bank of Japan. Kuroda delivered by announcing a 2% inflation target in two years and a massive quantitative-easing program to achieve it. So far "Abenomics" has pumped up equities, weakened the yen, increased inflation, and stimulated growth. Abe also seems to be pushing ahead with a broad set of structural reforms.

The unprecedented experiment could either restore the country’s mojo or send it hurtling into the abyss. If things work out, bond investors will get their principal back plus a de minimis yield. If not, they could lose a lot of money. It almost goes without saying that one is not necessarily being compensated for the risks Japanese bonds pose.

In addition, more than half the portfolio is invested in heavily indebted, slow-growing European countries like France, Italy, and Spain. While Europe has not engaged in a full-court press to restore growth, it’s also experimenting with unconventional monetary policy, led by the Bank of England. The European Central Bank under Mario Draghi has said it will "do whatever it takes" to keep the eurozone together, but bondholders are still left with low-yielding bonds in heavily indebted countries.

The fund does contain a smidgen of bonds issued by less-indebted emerging-markets countries like Korea and Russia; almost by definition a cap-weighted index keeps their weightings small. However, if one wants exposure to these high-yielding and less-indebted sovereigns, Vanguard Emerging Markets Government Bond Index (NASDAQ:VWOB) is arguably the best fund for it. It yields 4.6% and has a duration of about seven years. Needless to say, it’s a far better deal than this fund.

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: Diversification For The Sake Of Diversification