Seeking Alpha

Asymmetric Downside And Hidden Risk In International Bond ETFs

by: Logan Kane
Logan Kane
Macro, portfolio strategy, real estate, author

Diversifying into international bond ETFs was an effective 20th-century investing idea, and often a source of alpha. In the age of QE, this idea needs to be challenged.

For markets to be efficient, they need to be free. If central banks and politicians manage (manipulate) bond markets, then the assumptions of the efficient market hypothesis fall flat.

Somehow, United States-based investors with Vanguard became some of the largest holders of negative-yielding European and Japanese government debt.

In order to monetize negative-yielding bonds, the funds engage in short-term currency swap transactions. However, the duration of the swaps is mismatched with the duration of the underlying bonds.

If you own Vanguard's BNDX or other similar ETFs, you should think about selling them due to the unintended risk being taken.

Passive investing has historically helped more than it has hurt, but the current state of affairs in international bond ETFs illustrates the danger of blindly following investing dogma such as investing internationally with ETFs.

The problem: Financial advisors, 401(k) providers, and investors were taught that one can improve their investment portfolio by investing internationally. However, when this approach has been applied to investing in the stocks and bonds of countries that don't always follow the Washington Consensus of free markets, free trade, and maximizing shareholder returns, the result is often painful. These problems are compounded when investors ignore relative valuations of international stocks and bonds.

The Nikkei Problem

Case in point: In 1989, the price-earnings ratio for the Japanese Nikkei index was over 60x vs. roughly 14x now. Compounding the problem were cultural differences between Japanese and American management teams. Japanese management teams back in the day often ran companies in ways that benefited employees at the expense of shareholders, compounding the valuation problem. Only recently have Japanese companies warmed to the American model of paying healthy dividends and executing share buybacks. As such, the returns for investing in Japanese equities over the last 30 years were miserable. For what it's worth, 30 years later, I feel that the market is overly penalizing Japanese equities (EWJ) and that they could surprise the world and earn a couple of percentage points more per year than US equities (SPY) over the next 5-10 years. However, in the time that it took for Japanese stocks to go from overvalued to undervalued, entire investing careers have come and gone.

It isn't much of a stretch to draw parallels to the Japanese stock market in 1989 to the government debt markets today in Japan and Western Europe. It turns out that even other highly developed countries aren't as keen on free markets as the United States is (in spite of our tendencies to want to stabilize the business cycle).

Today, central banks in Europe and Japan have decided that they would like to print enough money to keep long-term bond yields negative. What could go wrong? For US-based passive investors, plenty. However, so far, investors have so far been rewarded with nothing but gains.

ChartData by YCharts

So who buys these bonds?

A significant portion of the bonds are bought by central banks themselves with printed money. Other buyers include pension funds and insurance companies that are constrained by their charters to allocate a certain amount of money to "risk-free" investments. A third group of buyers: mom-and-pop investors investing in international bond ETFs and mutual funds. A quick check showed that this third group holds a significant amount of assets, with perhaps $50 billion in negative-yielding assets in the largest international bond ETF, the Vanguard International Bond ETF (BNDX).

Vanguard is typically known for simplicity in its fund structures, but its international bond ETFs are a different animal. Vanguard invests hundreds of billions of retail investor dollars in international bonds, then enters into a network of currency swaps with multinational investment banks to hedge the FX exposure. This is nominally pretty smart, as the currency exposure from the bonds and the swaps cancels out. In the case of the international bond ETFs for, say, German Bunds, the currency swaps earn the dollar rate and pay the euro rate. This means US investors might currently earn 200+ basis points per year on the swaps, and maybe -50 basis points per year on the bonds (if the yield curve slopes positive and the fund rolls the bonds, they might avoid most or all of this loss).

However, in Vanguard's case, they might know just enough to be dangerous.

The duration of the interest rate swaps entered into is typically around 1-3 months, and the duration of the government bonds they own is around 10 years (assuming maturity and duration are equal, i.e. no coupons). This means that if cash rates change, then investors could lose a decent amount of money when hot money stops chasing the negative-yielding bond/positive-yielding swap trade.

To this point, here's a sampling of the currency contracts from the 140+ page semi-annual report for the fund in April.

Source: BNDX semi-annual report

As you can see, the maturities are all pretty short, and the long list of swap transactions and counterparties is not your typical Vanguard fund report.

This mismatch leads to unintended risk for Vanguard investors if one of the following happens:

1. The US decides to cut interest rates further and foreign bonds become less competitive with Treasuries.

2. Either Europe or Japan decides to abandon their negative interest rate experiment.

Either one of these events happening could deal losses to investors that could take years if not decades to recover. Hedge funds and banks can manage this risk by matching the duration of their assets with the duration of their swap liabilities (by either investing in shorter-term bonds or longer-term currency swaps, which trade up to 5-10 year maturities for the euro/dollar and yen/dollar), but Vanguard doesn't appear to be doing this.

The fundamental problem with much of the world's government bond markets right now is that markets are being managed by governments (closer to the Beijing Consensus) rather than by the natural forces of supply and demand. This isn't accounted for by those who base their investment decisions on a belief in free, competitive, and efficient capital markets.

In a normal market, a 10-year AAA or AA government bond trades for somewhere between the rate of inflation (soft lower bound) and the expected nominal rate of GDP growth (upper bound). For Germany or Japan, that means a rate somewhere between 1.5 and 3 percent is normal. For France, which has acceptable but slightly higher credit risk that means roughly 2 to 3.5 percent. The difference is due to central bank intervention. Historical examples of how similar situations have ended badly for investors include the ERM peg for the pound that broke in 1992 or the Swiss National Bank peg to the euro that broke in 2015.

This leads to the potential for asymmetric losses if central banks lose the political will to continue to manipulate bond markets. If European interest rates equalize with the current level of US interest rates and 10-year bond yields reach a yield around 2 percent in Germany (where they were as recently as 2013 before the negative interest rate experiment), 10-year bond buyers could see losses in excess of 25 percent, around 12x the current annual carry of the trade. While only 30-40 percent of the Vanguard's international bond holdings are trading for negative interest rates, this same problem is affecting the bonds of Eurozone countries like Italy and Spain which are getting to borrow far cheaper than they otherwise would, and European corporate bonds, which trade at a spread relative to ultra-low government bond yields.

The ECB wants the euro weak to boost exports and tourism and ease the debt burden on Southern Europe. Naturally, this drives savers in Northern Europe crazy, leading to political pressure to leave the euro or change monetary policy. Low rates for forever in Europe are not a foregone conclusion.

While I'm generally positive about passive investing, poor ETF construction is quite the trap for the unwary. For a notable example, the largest shareholder of Tanger Factory Outlet Centers (SKT) is a high-dividend ETF (SDY) with around 20-25 percent of its market cap. On the other side of the trade, so-called smart-money investors have sold short over 50 percent of the floating shares in the company. I'd prefer to be on the side of a consensus of hedge funds betting against the company and not on the side of a rigid, mechanical index designed for dividend-hungry investors. Part of why the track record is seemingly so good for passive investing is that the original index construction of the S&P 500 index was masterful. For example, excluding companies that don't turn a profit (the quality factor), market-capitalization weighting (the momentum factor), and deleting failing companies when they no longer meet inclusion criteria (both the momentum and quality factors) all lead to the efficient allocation of capital and strong returns for the S&P 500. If the index providers had decided to restrain their allocations to successful companies like Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), included money-losing companies in the index, or held onto bankrupt companies rather than reallocated capital into fresh companies, then passive investing may never have taken hold in the same way that it has. Poor index construction is often a problem in corporate bond ETFs, international equity indexes, and small-cap equity ETFs as well.

Asymmetric, complex risk like this is best left to professionals and not taken in your 401(k) for pennies in return. For this reason, I advise investors to consider shifting out of international bond ETFs and stick with US Treasury note and bond ETFs, such as the iShares 20+ Year Treasury ETF (TLT) or the 7-10 Treasury ETF (IEF). Vanguard's equivalent US Treasury funds (VGLT) do perform as intended as well. Competence and security selection are the most important factors in choosing investments, whether they're active or passive.

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Disclosure: I am/we are long MUB, BND. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.