(PUB) Vanguard Advisor

OVERSEAS INCOME Learning From Year One

Market lost money between May 2013 and May 2014. In other words, it did not provide all that much diversification. Additionally, the foreign bond fund’s performance edge shrinks when com- pared to the actively managed funds, as seen in the table to the left compar- ing the returns of the two international bond index funds to the performance of the actively managed bond funds in my Model Portfolios . I am keeping my Buy rating on Emerging Markets Government Bond. Many emerging market countries, with lower debt-to-GDP ratios and higher growth rates, actually look to be in bet- ter shape than their developed market siblings. Historically, emerging market bonds have been a decent diversifier to U.S. bonds. Plus, with a SEC yield Emerging Markets Government Bond did out- perform Total International Bond and Total Bond Market, but it did so with a good deal of risk. of 4.09%, it is one of the few places investors can find a decent level of income. But, once again, don’t forget about the risks—this fund is for the more adventurous fixed-income inves- tor who is prepared to withstand some sharp declines. If you are adamant about getting foreign bonds into your portfolio, Total International Bond is a fine holding, hence my Hold rating. Keep in mind that by design, its behavior shouldn’t be all that different from Total Bond Market. You also aren’t going to find much, if any, extra income here. With an SEC yield of 1.30%, Total International Bond yields less than Total Bond Market (2.00%) and Intermediate-Term Treasury (1.55%). I continue to think that using Vanguard’s actively managed funds will be a winning strategy. n

VANGUARD’S FORAY into foreign bond markets celebrated its first birth- day at the end of May 2014. While a year is typically too short to read much into, the first 12 months actually deliv- ered some valuable lessons on risk and return. But before getting to those lessons, let’s take a quick step back to review. After years of resistance and then anoth- er year of delay, Vanguard launched two foreign bond-based index funds in May 2013: Total International Bond Index and Emerging Markets Government Bond Index . Total International Bond, which aims to track an index of investment- grade corporate and government bonds from countries outside the U.S., also hedges currency risk back to the U.S. dollar. Vanguard found that foreign cur- rency exposure added an unacceptable level of risk, so its hedging is designed to give the fund more of a “bond-like” feel for U.S. investors. The fund has been the popular choice, with more than $24 billion in assets so far, includ- ing a nice $12 billion or so jumpstart when Vanguard added it to its Target Retirement , Star LifeStrategy and Managed Payout funds-of-funds right out of the gate. Emerging Markets Government Bond benchmarks against bonds issued in U.S. dollars by emerging market gov- ernments. Unlike its sibling, there are

Active Managers Keep Up With Foreign Indexes

May '13– May '14

High-Yield Corporate

6.3% 4.4% 3.6% 3.4% 2.2%

Emerging Markets Gov’t Bond Index Total International Bond Index Intermediate-Term Investment-Grade Short-Term Investment-Grade

no corporate bonds here, and the fund only holds dollar-denominated bonds, so it doesn’t have to hedge its currency exposure. The fund has struggled to gain traction, with only $277 million in assets through the end of May. A year ago, in the June 2013 issue, I said that while I thought Emerging Markets Government Bond was more interesting, I cautioned that the risk was higher as well. As for Total International Bond, I felt that it was okay, but didn’t see much of an argument for the fund, especially compared to the best of Vanguard’s actively managed funds. How did those predictions play out? Emerging Markets Government Bond did outperform, returning 4.4% in its first year, compared to Total International Bond’s 3.6% gain and Total Bond Market ’s 2.3% return. But it did so with a good deal of risk. In its first three months, the fund was down 6.1%, which is a larger drawdown than Total Bond Market has experi- enced at any point since its December 1986 inception. Could you find higher returns? Yes, but they came with a price. While Total International Bond did outperform Total Bond Market, their performance was very similar. In the chart to the left, which shows growth of $100 invested in the three bond index funds, you can see that Total International Bond and Total Bond Market cut a nearly identical route— especially compared to the emerg- ing market fund. Consider that Total International Bond lost money in four of the five months where Total Bond

Bond Index Funds Tracking Similar Paths

100.00 102.00 104.00 106.00

88.00 90.00 92.00 94.00 96.00 98.00

Total Bond Market Total Int’l Bond EM Gov’t Bond

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12 • Fund Family Shareholder Association

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