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A Look Inside Vanguard’s International Bond Funds

Vanguard originally announced their two new international bond funds back in 2011. But things moved somewhat more slowly than anticipated, and the funds weren’t made available to investors until May and June of this year.

But now the funds are available, their portfolios are in place (i.e., the funds no longer hold just cash, as they did when they were brand new), and Vanguard’s website has all the standard information about the funds’ holdings. So let’s see what they look like, shall we?

Vanguard Total International Bond Index Fund (VTABX)

Vanguard’s Total International Bond Index Fund is the one that has been added to the LifeStrategy and Target Retirement funds. Here’s a quick breakdown of key facts:

  • Expense ratio: 0.20% for Admiral shares (with a $10,000 minimum), 0.23% for Investor shares.
  • Average duration: 6.7 years, meaning this fund should be slightly more volatile than Vanguard’s Total Bond Market Index Fund (with its average duration of 5.5 years).
  • SEC yield: 1.66%, which is slightly lower than the current SEC yield of 2.00% on Vanguard Total Bond Market Index Fund.
  • Credit risk: Slightly higher than Vanguard’s Total Bond Market Index Fund, with the largest part of its holdings being AA-rated bonds rather than U.S. Treasury bonds.
  • Currency risk and inflation risk: Because the fund will be currency-hedged, currency risk should be minimal, and inflation risk should be comparable to that of any dollar-denominated nominal intermediate-term bond fund.

In short, relative to the domestic “total bond” fund, the new “total international bond” fund is slightly more expensive, has slightly more interest rate risk, slightly more credit risk, and a slightly lower yield. When viewed as a stand-alone investment, it’s not exactly the sort of thing I’d be rushing to get my hands on.

On the other hand, similar arguments (higher costs, higher risk, and, at some points in time, lower yield) can be made about international stock funds relative to U.S. stock funds, yet most of us have decided to include international stocks in our portfolios because they offer diversification — diversification both in the sense of holding more total securities and in the sense of offering less-than-perfect correlation with U.S. stocks and bonds. And the same diversification-based arguments can be made for international bonds. (See this paper from Vanguard making that case, for instance.)

Vanguard Emerging Markets Government Bond Index Fund (VGAVX)

While the new Total International Bond Index Fund is, overall, fairly similar to the domestic Total Bond Market Index Fund, Vanguard’s new Emerging Markets Government Bond Index Fund is an entirely different beast due to its level of credit risk and its corresponding yield.

  • Expense ratio: 0.35% for Admiral shares (with a $10,000 minimum), 0.50% for Investor shares.
  • Average duration: 6.5 years.
  • SEC yield: 4.67%.
  • Credit risk: 80% of the portfolio is rated Baa or below. (For reference, Baa is the lowest credit rating that still qualifies as “investment-grade” rather than speculative/junk.)
  • Currency risk: None, because the fund invests in dollar-denominated bonds.
  • Inflation risk: Comparable to any intermediate-term nominal bond fund.

With a yield and credit quality breakdown like that, it’s just barely outside the range of a junk bond fund. (By way of comparison, Vanguard’s High Yield Corporate Fund has a yield of 5.08%.)

So, for those looking for a high-risk bond fund to act as a potential diversifier, how does this fund compare to a high-yield U.S. corporate bond fund? Based on the very limited information I’ve been able to find (namely, comparing the correlation figures in the Vanguard paper I linked to above to correlation figures I calculated for high-yield bonds), it looks like:

  • Emerging market government bonds have a slightly lower correlation to U.S. and international stocks than high-yield corporate bonds do (which makes some intuitive sense, given that emerging markets government bonds seem to have less of a natural connection to the U.S. stock market than high-yield U.S. corporate bonds do), but
  • Emerging market government bonds have a significantly higher correlation to U.S. investment grade bonds than high-yield U.S. corporate bonds do.

In other words, it’s not clear that this fund is a better or worse diversifier than a high-yield corporate bond fund for a typical U.S. investor. (Though it’s important to note that the data in the Vanguard paper on correlations is only for the brief period 2002-2010, so it doesn’t necessarily tell us much about the future.)

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