Last week’s launch of the first foreign bond ETF in the U.S. has received a muted reception so far, but it looks like a big deal to us. Diversification is the reason.
Yes, actively managed funds targeting foreign bonds have been around for years. But with the arrival of SPDR Lehman International Treasury Bond ETF (Amex: BWX), the asset class’s beta is now finally available in something approaching its pure form. The first foreign bond index fund, in other words, is here.
That’s good news for a number of reasons, starting with the price of entry. Consider that there are 84 “world bond” mutual funds (distinct portfolios), according to Morningstar Principia software. (There are another 26 “emerging markets bond” portfolios, but we’re overlooking this group since the new ETF focuses on investment grade government debt.) The gross expense ratios for world bond funds range from a high of 4.99% (ouch!) down to 0.19%. Sixty-six of the 84 portfolios charge 0.51% or higher, which is to say that 66 world bond mutual funds charge more than the 0.50% expense ratio for new foreign bond ETF.
True, 0.50% isn’t cheap when compared with the lowest fees in the ETF universe, which is as low as seven basis points. But foreign bonds aren’t your garden variety asset class, which is why it’s taken so long to see this corner of the marketplace indexed. Meanwhile, 50 basis points isn’t so high as to destroy the fundamental case for buying this slice of beta.
The basic appeal of foreign bonds is the diversification benefits they offer to most other asset classes. As the table below shows, there’s low and in some cases virtually zero correlation between foreign bonds (represented here by the Citi World Gov’t Bond Index Non-$ Index, unhedged) and the major asset classes. You’d expect no less between stocks and bonds generally, and foreign bonds certainly live up to that expectation. But what’s surprising is the low correlation between foreign bonds and U.S. bonds, as measured by the 0.38 correlation for the three years through last month for the Lehman Bros. U.S. Aggregate and the Citi WGBI.

Strategic-minded investors should also take note that there’s low correlation between foreign bonds and commodities, REITs and high-yield bonds. Rarely has so much diversification been available for just 50 basis points. Indeed, how many investors are paying 2 and 20 for hedge funds on the belief that adding “alternative investments” will bring diversification benefits?

Simply stated, foreign bonds pack a diversification punch, raising the potential for enhancing risk-adjusted returns. One reason that foreign bonds march to the beat of their own drummer is the fact that economic and inflation cycles differ in nations around the world. Bonds, being sensitive to such factors, invariably move differently in one nation vs. another. This independence of cycles will prevail until and if there’s one central bank dispensing one currency for everyone (don’t hold your breath).
That leads us to the second factor: currency. Owning overseas bonds means buying securities denominated in currencies other than the greenback. As such, investors are embracing a risk factor that’s not generally used in conventional portfolios of stocks, bonds or even commodities (which are generally priced in dollars around the world). Yes, forex is a volatile realm, fraught with more than a few dangers, particularly for the uninitiated. On the other hand, the risk is easily contained by limiting foreign bond portfolio weightings to reflect one’s tolerance for such hazards.
In fact, the forex effect will probably do more good than harm over time when used in moderation and in context with other risk factors. That’s because diversification’s value increases as you tap more risk factors, particularly when the factors are largely independent from one another.
As for the new ETF, it’s encouraging to learn that the portfolio will track the Lehman Brothers Global Treasury Ex-U.S. Capped Index (in unhedged dollar terms), which targets non-U.S. investment-grade government debt. By and large, the portfolio will hold sovereign bonds issued by nations in the developed world and the currency factor won’t be hedged. The “capped” reference reflects the index’s efforts at keeping Japan’s prodigious supply bonds from dominating the portfolio and thereby causing havoc with the regulatory constraints that require ETF portfolios to be “diversified.”
To date, U.S. investors, particularly retail investors have yawned at the opportunities available in the foreign bond market. If you add up the assets in mutual funds and ETFs with some degree of foreign bond exposure, it’s well under $100 billion. That’s peanuts compared to the roughly $20 trillion-plus of foreign bonds with maturities of one year or more in the world, according to numbers from the Bank for International Settlements. Most of the planet’s fixed-income securities are outside the U.S., suggesting that a portion of a diversified portfolio should look beyond the U.S. when it comes to bonds.