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Vanguard’s New International Bond Funds

Vanguard recently announced that they’ll be adding two new index funds to their lineup in early 2012:

  • Vanguard Total International Bond Index Fund, which will hold government bonds, agency bonds, and corporate bonds from countries other than the U.S.; and
  • Vanguard Emerging Markets Government Bond Index Fund, which will hold highly-rated government bonds from emerging markets.

As with the recently-announced changes to the LifeStrategy funds, I thought it might be helpful to take a look at these new funds to see whether or not they merit inclusion in your portfolio.

How Are the Costs?

  • The Total International Bond Index Fund will have a 0.30% expense ratio for Admiral shares and ETFs, as well as a 0.25% purchase fee, and
  • The Emerging Markets Government Bond Index Fund will have a 0.35% expense ratio for Admiral shares and ETFs, and a 0.75% purchase fee.

Compared to most international bond funds, that’s pretty low. However, it’s still more expensive than Vanguard’s domestic bond funds. For example, Vanguard’s Total Bond Market Index Fund has an expense ratio of just 0.11% for Admiral shares and ETFs, and it has no purchase fee.

Is the Diversification Worth the Cost?

My initial thought — important caveat: I’m not an economist. This is just average-Joe-type commentary here — is that international bonds could offer a diversification benefit, with the simple reason that interest rates in the U.S. are largely affected by the actions of the Federal Reserve, whereas rates in other countries are going to be more heavily impacted by the actions of their own respective governments.

And it doesn’t seem unthinkable that different countries might have different economic priorities at a given time — which could lead to different monetary policy, different interest rates, and different bond market performance.

A research paper put out by Vanguard earlier this year, offers us some historical data that supports the idea that international bonds offer a bit of a diversification benefit.

The paper showed that the monthly returns of international bonds (as measured by the Barclays Capital Global Aggregate ex-USD Hedged Index) had a 60% correlation to the monthly returns of U.S. bonds (as measured by the Barclays Capital U.S. Aggregate Bond Index) from 1988-2010. That’s significant correlation, but it’s still low enough to suggest that international bonds could be helpful.

The paper also showed that from 1985-2010, for a 60% stock, 40% bond portfolio, as you move more of the bonds from domestic to international, the portfolio’s overall monthly volatility decreases slightly.

While these two data points do give some indication that holding international bonds is likely helpful, they’re not exactly overwhelming. And as always when using historical data, we must remember that it’s just that — historical. We don’t know whether international bond diversification will be more helpful, less helpful, or even detrimental going forward.

So Should You Buy Them?

Despite the fact that I can see some use for holding international bonds, there are two reasons, I think many investors would be better off waiting at least a few years before moving a significant amount of money into either of the new funds.

First, it wouldn’t surprise me to see the funds’ expense ratios come down a bit as they grow in size.

Second (and more importantly), most of us have little to no experience investing in (or even reading about!) international bonds. And I don’t think it’s a good idea to put much of your money into something until you’ve been watching it for long enough to have a good handle on how it tends to behave.

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Comments

  1. Mike, considering that Vgd’s TBM already has a 5+% investment in foreign bonds, would that provide a diversification benefit in itself if one has a substantial allocation in that fund?

  2. Larry,

    In theory, yes, I would think so. In practice, I’m doubtful the 5.5% allocation is going to make much difference one way or another.

    In the paper from Vanguard, the volatility reduction from allocating more to international bonds was very modest. So to the extent that the future looks like the past, a 5% allocation wouldn’t really produce any noticeable benefit.

  3. Sounds then like something not to rush into.

  4. I’d also vote for a wait and see approach.

    Mostly, I wonder what hidden costs and risks might accompany the currency hedging to be used in the future Total International Bond Index Fund. Most index funds are much easier to understand, and it’s usually a bad idea to invest in a product that one doesn’t understand.

    This year, one employee allegedly cost UBS $2.3 billion on currency futures deals that it thought were hedged.

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