Are you invested in the largest asset class in the world? You might think you are, but chances are you’re not.
Based on data compiled by Vanguard in 2012, the world’s largest asset class is international bonds, with more than 35% of the global capital markets pie. Even though this market segment has begun to attract more cash — $27 billion flowed into world-bond and emerging-market funds in 2012, according to Morningstar — most Americans remain under-invested in foreign bonds.
Investors aren’t missing much right now because the overseas bond markets are suffering from the same problem as our own: exceptionally low yields. The 30-day SEC yield on SPDR Barclays International Treasury Bond ETF (NYSE:BWX) is currently 1.55%, exactly the same as iShares 7-10 Year Treasury Bond ETF (NYSE:IEF), a U.S. government bond fund with about the same duration (interest rate sensitivity) as BWX. Given that BWX is more volatile than IEF, it offers less in the way of risk-adjusted returns. The fund also is highly correlated with the U.S. market, indicating that it also isn’t providing much in the way of diversification.
Further, investors should question whether funds that are tied to developed-market government bond benchmarks provide the kind of diversification they really want.
Such funds are heavily exposed to Japan, where government debt is higher and economic growth is slower compared to the United States, as well as the United Kingdom, which Moody’s just downgraded from its top Aa1 rating late last week. In this sense, the core problems in the largest countries are very similar to those of the United States.
Another would-be selling point of some international bond funds is that their holdings are denominated in foreign currencies, which provides diversification out of the U.S. dollar. In the case of developed-market funds, however, this diversification is largely into currencies — the yen, euro and British pound — that face the same long-term challenges of low economic growth and heavy central-bank monetary accommodation that are depressing the long-term outlook for the dollar.
Add it up, and funds heavily tilted toward developed-market government bonds currently have very little to offer.
Are Emerging Markets the Answer?
Those who are put off by the low yields on BWX and its short-term counterpart SPDR Barclays Short Term International Treasury Bond ETF (NYSE:BWZ) — yielding just 0.78% — face the same challenge they face with the domestic options: If you don’t want to settle for yield less than the rate of inflation, you’re going to have to go out the risk curve.
Unfortunately, the options in the higher-risk market segments aren’t much better. While emerging markets traditionally have been the destination for those who want to pick up some extra yield overseas, the yield advantage is very narrow at present. The iShares JPMorgan USD Emerging Markets Bond Fund (NYSE:EMB), the largest ETF in the asset class, is offering a 30-day yield of just 3.66%.
That might be better than most bond funds, but it still isn’t providing adequate compensation for the potential downside if the markets go back into risk-off mode. Recall that EMB shed about 4.5% in a month last spring when concerns about Europe re-emerged; at current yield levels, that would wipe out nearly 15 months of return from income. With the fund already up 12.6% from its June low, the dicey risk-and-return profile becomes more of an issue.
Emerging-market corporate bonds aren’t necessarily the answer, either. This market segment has garnered a good deal of attention in the past year with the launch of ETFs such as the WisdomTree Emerging Markets Corporate Bond Fund (NASDAQ:EMCB), but even this fund is offering a yield of just 3.8% — meaning investors are being paid even less for the risks right now than they are in EMB.
Funds to Consider
This leaves us with two choices.
First, income-oriented investors should take a look at international high-yield funds such as Market Vectors International High Yield Bond Fund (NYSE:IHY), which has a 30-day SEC yield of 5.5%, or Market Vectors Emerging Markets High-Yield ETF (NYSE:HYEM), which currently sports a yield of 5.8%. While both are high-risk, they also are on the high end of the yield spectrum and they have the potential for longer-term outperformance for those who can stomach stock-like volatility. However, the two funds are up substantially from their June lows — 21% and 17%, respectively — so it likely will pay to be patient and wait for a better entry point.
The second option is emerging-market funds denominated in local currencies. The Wisdom Tree Emerging Markets Local Debt Fund (NYSE:ELD) is an interesting choice for longer-term investors because it provides diversification out of the U.S. dollar without the exposure to other, equally unattractive developed-market currencies. Instead, ELD is invested in the currencies of countries with much stronger government finances and better economic growth, which provides more latitude for longer-term appreciation. As is the case with IHY and HYEM, however, strong recent performance indicates that there’s no reason to jump in right away.
The Bottom Line
The foreign bond markets offer a similar profile to what investors face domestically — accept low yields or take a chance on higher-risk, somewhat inflated assets. But on a longer-term basis, the asset class still provides its share of opportunities for longer-term investors who can handle high short-term volatility.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.