The Case For International Bond ETFs

While ETF providers scramble to cover every nook and cranny of the market, one asset class is glaringly absent from the lineup: international fixed income.

Bonds issued in foreign currency should be staples of well-diversified portfolios. A vast amount of financial literature supports this view, highlighting their importance in reducing risk and improving overall longer term returns.

During inclement investment market periods - when you need diversification the most – bonds play a particularly vital role in managing risk and safeguarding capital — certainly so in countries with a proclivity for declining currencies.

Benefits of Bond ETFs

Costs. Bond ETFs carry all the same benefits as equity ETFs – ease of purchase, high liquidity, tax efficiency and one-stop diversification. Government, corporate and high-yield fixed income ETFs are all available (only domestic-oriented, for now). They can also be purchased at a far lower cost than their mutual fund counterparts. In fact, actively managed bond funds have substantially higher fees, coupled with a dismal track record of generating alpha over the long run. With low real yields and lofty valuations in many asset classes, lower returns are quite probable over the next several years. In this type of environment, maintaining low expenses will be crucial.

Maintenance of a constant credit quality and duration profile. Without having to directly purchase bonds and roll them over at maturity each time, preserving durations in the fixed income component of active strategies becomes much more convenient with ETFs.

Pricing transparency: historically only available at the institutional level, pricing transparency has been a further advantage for individual investors.

The Case for International Bond ETFs

Higher returns and risk reduction are the primary rationales for investing in foreign bonds. But diversification benefits are only experienced when correlations are sufficiently low, as measured against other portfolio holdings. In recent years, many asset classes with traditionally low correlations have seen a much higher correlation with the general stock market. This heightened correlation is emblematic of latter phases in lengthy bull market cycles (as exhibited in the financial market boom witnessed over the last few years). The implications are quite serious, as this decreases their utility as risk-reducing portfolio diversifiers and may lead to a false sense of actual diversification.

Fortunately, many segments of the foreign bond market have retained their low correlation status. In fact, international fixed income is currently one of the few remaining assets with low correlation statistics, even as measured from multiple currency domiciles.

With the US economy on recession watch and many financial markets looking stretched, current market conditions are characterized by growing risks and unfavourable valuations. Incorporating low or negatively correlated conservative assets with reasonable return prospects is now appropriate – foreign fixed income can certainly fill part of that role.

Emerging Asian Bonds Attractive

Asian bonds are an excellent example of a foreign fixed income market with low correlation qualities, in addition to higher yields, attractive value and sufficient liquidity. Improving credit quality, significantly undervalued currencies and positive structural economic reforms in the emerging Asian region bode well for future returns. Importantly, regional Asian bonds exhibit negative correlations to many markets including their own stock market and the more developed G7 bond markets.

Consider the Hong Kong listed ABF Pan Asia Bond ETF (HKSE:2821), a basket of Asian currency denominated bonds issued by both government and quasi-government organizations in developing Asia. This ETF carries a mere 16 basis point expense ratio. Unfortunately, an investment such as the ABF Bond ETF is not easily available to Canadian or US retail investors since it is only accessible on international exchanges. Crosslisting (i.e. securities with listings on multiple exchanges) these types of investment is becoming more common and would be a solution towards foreign bond access.

Conclusion

Fixed income has never been a glamorous component of investor portfolios — and certainly not exciting enough for many on the Street. But the hallmarks of capital preservation, safety and diversification make bonds a critical constituent in successful portfolio management.

Comments

[David Jackson:]

Totally agree with your comments about the need for foreign bond ETFs.

But it's still not clear why it's taken the ETF providers so long to bring out international bond ETFs. You would have thought they'd have come out before the currency ETFs, no?

2007 Apr 16 05:02 AM

[Aquater:]

Very insightful article. Great judgment. Maybe ETF providers will rush to create international bond ETFs when that sector becomes hot. They just love to chase performance while telling the retail investors not to do so!

2007 Sep 04 02:50 AM

[ZardozZ:]

Given the falling dollar and the Yen Carry trade unwinding one would think that Barclays and others would see the value in setting up an International Bond ETF for those portfolios approaching retirement and would like to diversify income assets to get exposure to foreign markets without paying outlandish Loads and 12b-1 fees.. !! Grear article

2007 Sep 21 08:58 PM