12
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Fund Family Shareholder Association
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
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
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
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
OVERSEAS INCOME
Learning From Year One
Bond Index Funds Tracking
Similar Paths
5/13
6/13
7/13
8/13
9/13
10/13
11/13
12/13
1/14
2/14
3/14
4/14
5/14
Total Bond Market
Total Int’l Bond
EM Gov’t Bond
88.00
90.00
92.00
94.00
96.00
98.00
100.00
102.00
104.00
106.00
Active Managers Keep Up
With Foreign Indexes
May '13–
May '14
High-Yield Corporate
6.3%
Emerging Markets Gov’t Bond Index
4.4%
Total International Bond Index
3.6%
Intermediate-Term Investment-Grade
3.4%
Short-Term Investment-Grade
2.2%
Emerging Markets
Government Bond did out-
perform Total International
Bond and Total Bond
Market, but it did so with a
good deal of risk.
