International Bond ETFs: Diversity and Safety

International fixed income markets have traditionally been expensive to access. But in the last couple of years the introduction of several ETFs have made access cheaper and easier. Diversification, dollar hedging, and strong yields make exposure to these ETFs appealing.

The first and, by market capitalization, the largest international bond ETF is the SPDR Barclay's Capital International Treasury Bond (NYSEArca:BWX). BWX competes with two new iShares products: iShares S&P/Citi International Treasury Bond (NasdaqNM:IGOV) and the shorter term iShares S&P/Citi International 1-3 Year Treasury Bond (NasdaqNM:ISHG). BWX also competes less directly with a couple of international fixed income ETFs with an emerging markets focus: PowerShares Emerging Markets Sovereign Debt (NYSEArca:PCY) and iShares JPMorgan USD Emerging Markets Bond (NYSEArca:EMB). And finally there is a TIPS-like product, the SPDR Deutsche Bank International Government Inflation Protected Bond (NYSEArca:WIP) which holds bonds indexed to inflation.

An ETF holding debt issued by sovereign governments around the world and denominated in a variety of currencies would seem to be the very epitome of safety and diversification. And indeed, when the equity markets fell sharply in the fall of 2008, BWX was among the very few ETFs that did not suffer significant losses. The chart below shows the performance of BWX compared to other asset classes represented by ETFs: the US equity benchmark Standard and Poor's Depositary Receipts (AMEX:SPY), the PowerShares Deutschebank Commodity Index (PCX:DBC), which tracks a basket of commodities including oil, SPDR GoldShares (NYSEArca:GLD), which tracks Gold, and the iShares Wilshire International Real Estate (NYSEArca:RWX).

The chart indicates how commodities (represented by DBC) and REITs (represented by RWX) fell in tandem with the SPY, failing therefore as an equity hedge. BWX and gold were less correlated, performing similarly through December. In fact, BWX would have outperformed gold were it not for its dollar hedge: the dollar strengthened significantly during this period causing losses for BWXs euro-denominated holdings. Nevertheless, the dollar diversification that BWX provides makes good sense for any fixed income investor with a dollar dominated portfolio.

The chart below compares the performance of BWX with other international bond funds: the EM-focused PCY and EMB. The chart also shoes a fixed income benchmark, the iShares Barclays Aggregate Bond (NYSEArca:AGG), which holds US government and agency debt and the equity benchmark SPY.

As the chart shows, though they subsequently recovered, the high correlation of PCY and EMB with the SPY through September suggests that international emerging market debt provides a poor equity hedge in a crisis. This may at first seem unintuitive. Why should Turkish or Peruvian sovereign bonds track a U.S. equity benchmark? The answer is that the financial crisis was marked by a flight-to-quality that invited correlation even with basically dissimilar assets and historically dissimilar performance. Proof of this is the subsequent bounce of PCY and EMB in the December and the weaker broad marklet correlation witnessed in the first months of 2009.

There are two questions that arise when considering debt repayment: will a bond be repaid, and if so, what will it be worth at that time? Because the bonds held in BWX are denominated in the currency of the countries issuing the debt: Japanese bonds denominated in yen, French bonds denominated in euros, etc. it is assumed that the bonds will be repaid. It is assumed that the only question about the value of these instruments applies at such time as they are repaid. This is not true for EM debt. Unlike the yen and euro-denominated debt held in BWX, the debt held in PCY and EMB is dollar-denominated. Because countries issuing dollar-denominated debt have to have something to exchange for dollars (they cannot simply print dollars) default is never out of the equation.

There is compensation for the additional risk of investing in EM debt. In terms of yield, PCY and EMB pay around 7%, double that of BWX. Unfortunately, even 7% may not be enough. The global downturn has once again raised the chances of default. Ecuador defaulted in 2008. The Ukraine, receiving cash infusions from the IMF to pay for its gas supplies, is considered to be close. Hungary also will get help. Though the diversification away from a single market provided by these ETF will spread the risk of default, EMB and PCY are fairly highly concentrated funds. Around 5% of PCY for example is invested in a single Hungarian issue. EMB has a full 12% invested in a Russian Federation floater.

As is well publicized, to fund bank bailouts and stimulus packages the US and Europe are issuing massive amounts of new debt. The US public is supposed to develop an appetite for US debt to make up for the buying fatigue of Asian governments. But the US public, despite historic losses in the equities market, has yet to really take the bait. Meanwhile German bund and the United Kingdom's gilt auctions are failing to meet targets. So if the triple-A rated UK and Germany are having a hard time finding buyers, and the US is hunting around for new blood, what will happen to, say, Peruvian debt issuance? Another worry: shrinking trade surpluses for EM countries mean that foreign currency has been harder to come by making it more expensive to raise capital. Of course, as the world economic engines recover this becomes less of a problem. A bet on EM debt is a bet on speedy economic recovery.

Problems of default and over-supply are partially addressed by what is perhaps currently the best deal among international bond ETFs, WIP, the International Government Inflation protected bond fund. WIP holdings are highly diversified and mostly denominated in the local currency. The problem for WIP is yield. WIPs yield is below even BWX, and in the current deflationary environment inflation indexed securities seem unattractive.

Governments world-wide have met the financial crisis with stimulus packages and bail out money. From the U.S. to Germany to Venezuela these governments are funding programs or filling budget gaps with a flood of new debt issuance. Over the longer term, stimulus money risks inflation and higher interest rates. Over-supply of government debt also points to higher interest rates down the road. The owners of sovereign debt held in funds like BWX and ISHG will not have to worry about the return of capital, which as the chart above shows is great in a crisis, but they will be hurt by inflation and oversupply. Purchasers of emerging market debt through vehicles like PCY and EMB have an additional worry: sovereign default. WIP may provide the best safety of these ETFs but in the meantime pays an inferior yield.

International Bond ETFs and Expense Ratios:

SPDR Barclay's Capital International Treasury Bond (NYSEArca:BWX), 0.5%

iShares S&P/Citi International Treasury Bond (NasdaqNM:IGOV), 0.35%

iShares S&P/Citi International Treasury 1-3 Year Bond (NasdaqNM:ISHG), 0.35%

Emerging Market Focus:

PowerShares Emerging Mkts Sovereign Debt (NYSEArca:PCY), 0.5%

iShares JPMorgan USD Emerging Markets Bond (NYSEArca:EMB), 0.6%

Inflation-Protected:

SPDR Deutsche Bank International Government Inflation Protected Bond (NYSEArca:WIP), 0.5%