(This article was co-produced with Hoya Capital Real Estate)
In my last article here on Seeking Alpha, I reviewed the Vanguard Total International Bond ETF (BNDX). I suggested that investors think twice before turning down international bonds.
In which In the comments section, several readers responded that while they appreciated the article and the fact that I brought this particular asset class to their attention, they appreciated the low rate of return offered by BNDX, combined with the perceived level of uncertainty of other, safer options to invest available embarrassed them.
Interestingly, amidst these comments, a reader suggested I “take a look at VWOB.”
I responded to what I intended, noting that I currently hold this ETF in my personal portfolio. With this article, I will be keeping my word and recommending the Vanguard Emerging Markets Government Bond ETF (NASDAQ: VWOB).
A brutally honest look at emerging market government bonds
In this section, I’ll summarize some recent research by Charles Schwab and Vanguard and try to tie it all together to give the reader a strong sense of the risk/reward trade-off of emerging market government bonds at this particular point in time.
Let’s get the bad news out of the way first. This is the third time I have reviewed this particular ETF. The first was back on November 17, 2021 and was priced at $77.42 per share. I returned for a second round of punishment on March 8, 2022 when I suggested that EM debt might be too cheap to ignore. At that point, the price was $69.45. In the meantime, that price has fallen well below $60 at some point and has recovered to around $64.50 as of this writing.
Why did all this happen? Take a look at the next two charts from Schwab Research, based on data from Bloomberg.
As one can easily see, after a period of extreme weakness, the dollar has steadily appreciated against a basket of foreign currencies.
This is due to what Schwab calls the “Trifecta of Factors”. Specifically: 1) The relatively strong performance of the US economy, 2) monetary tightening by the Federal Reserve, and 3) safe-haven buying.
Unsurprisingly, this combination of factors is particularly bad for emerging market currencies, an example of which is shown in this next chart.
All of this, in turn, creates challenges for emerging market debt, including sovereign debt. Why? Because these debts are denominated in US dollars. As such foreign currencies depreciate against the dollar, such debts become more difficult to repay.
So is it surprising that VWOB has performed so well over the past few months?
Let’s stick with the negative side of the story for a bit longer. If you look at the first chart offered above, you’ll see that the tide has turned just a little lately. As the bond market appears to anticipate a recession in our future, longer-term interest rates have fallen. Slowing US economic growth could result in slower dollar appreciation against other currencies.
At the same time, the other two factors in this trifecta, particularly the fact that the dollar remains a safe haven, seem to imply that dollar strength is not going to completely disappear any time soon.
Given all of this, what could be the bull case for emerging market government bonds?
For this we turn to Vanguard Research. In the chart below, Vanguard points out that this particular asset class has an intriguing risk-reward profile over long periods of time.
As can be seen, the asset class is almost on a straight line between US Treasuries and the S&P 500. Although EM Treasuries are technically bonds, their risk-return profile is actually somewhere between bonds and equities.
Why might the risk/reward profile be particularly interesting at this point? In short, because of the current price. You see, this particular asset class was one of the first to be hit by changing economic conditions. The emerging markets sell-off began in late 2021 (ironically right around the time I originally recommended it). As a result, it can be argued that it is on the recovery path earlier than other asset classes.
Also, keep in mind that this is government debt. Although it is not without risk and defaults can and do happen, recovery rates are higher in this case too, as countries do not completely disappear as companies do and they have strong incentives to pay off their debt as much as possible under the worst of circumstances.
Vanguard Emerging Markets Government Bond ETF – Dive
While I won’t rewrite nearly everything I’ve written in my previous reviews, I’ll include a summary of some basic details about the ETF here so you don’t have to read multiple articles to get those details.
Regarding expenses, last February 25, Vanguard announced expense ratio changes for 18 funds across multiple ETF and mutual fund share classes, including a wide range of international strategies. One of those changes impacted VWOB, with its expense ratio falling from 0.25% to 0.20%. Another “win” for investors in this ETF!
VWOB seeks to track the performance of a benchmark index that measures the investment return of US Dollar-denominated bonds issued by governments and government-related issuers in emerging markets. The Fund employs an index investment approach designed to track the performance of the Bloomberg USD Emerging Markets Government RIC Capped Index.
Here, from the fund’s statutory sales prospectus, a somewhat deeper insight into his commitment:
This index includes US dollar denominated bonds issued by emerging market governments and government-related issuers with maturities greater than one year. The Index is capped, meaning that its exposure to any particular bond issuer is capped at 20% and its total exposure to issuers that individually make up 5% or more of the Index is capped at 48%. If the composite index, based on market weights, exceeds the 20% or 48% limits, the excess is reallocated to bonds from other constituent issuers.
With that, let’s address a few specifics related to the risk-reward analysis I offered in the previous section. All graphics are from the Vanguard Investors website for VWOB.
First, an overview of the composition of the overall portfolio.
Needless to say, this ETF is an interesting partner for all readers who, after reading my last article, are inclined to add a bit of BNDX to their portfolio.
In contrast to an average coupon of 1.8% and a yield to maturity of 3.9% for BNDX, the values here are roughly double. Interestingly, while average effective maturity is quite a bit longer in VWOB, average duration is about the same as BNDX.
- NOTE: If you are unclear about the difference between maturity and durationI offer a pretty nice overview in this article from about 4 years ago.
So, of course, if one wants to add international bonds as an asset class to one’s portfolio, one can start with a foundation of BNDX and then “pimp” the level of dividend income by mixing in whatever level of VWOB one feels comfortable with.
Let’s continue with a look at geographic footprint. Since VWOB is all about emerging market government bonds, I’ve decided to take enough of the chart to list the top 10 countries. Please note that the entire list can be easily viewed on the Vanguard website.
Just a quick note here, courtesy of Vanguard:
Emerging market debt is significantly more diversified than ever, with numerous new issuers from both ends of the credit spectrum. The category includes low-income countries from sub-Saharan Africa and wealthy oil exporters from the Persian Gulf. A more diversified issuer base leads to less idiosyncratic risk and more active management opportunities.
Next we move on to credit quality.
Here, to be clear, the level of risk increases to achieve that higher dividend yield. At BNDX, about 20% of the debt is rated BBB or below. For the VWOB, this figure is around 70%.
Finally, the effective runtime distribution.
Just a note on the approximately 28% of bonds in the VWOB with a maturity of 20 years or more. You might see this as a kind of double-edged sword. On the one hand, this leads to higher volatility. On the other hand, yields on emerging market debt can be very high as these longer maturities can sustain price appreciation as countries seek to improve their credit fundamentals.
Summary & Conclusion
As always, I hope to have given you something to think about.
You may decide, given the risks I have outlined, that attribution to VWOB is not appropriate for you. Please think about this word at the same time, allocation. It can be anything you feel comfortable with.
Let’s think about a conservative portfolio. What if you allocate a total of 3% international bonds and split them between 2% of BNDX and 1% of VWOB?
In terms of diversification, you would expand your horizons beyond the shores of the US and earn some dividends as well as moderate potential for long-term gains.
I’d love to hear your comments, questions, and even critiques in the comments section below.