(This article was co-produced with Hoya Capital Real Estate)
In my most recent article here on Seeking Alpha, I reviewed Vanguard Total International Bond ETF (BNDX). I suggested investors think twice before rejecting international bonds.
In the comment section, several readers responded that while they appreciated the article and the fact that I brought this particular asset class to their attention, the paltry return offered by BNDX, combined with the level of uncertainty perceived when other safer options are available has left them in a dilemma.
Interestingly, in the middle of these comments, a reader suggested I “check out VWOB”.
I responded to the effect I intended to have while observing that I currently hold this ETF in my personal wallet. With this article, I will keep my word and review the Vanguard Emerging Markets Government Bond ETF (NASDAQ: VWOB).
A Brutally Honest Look at Emerging Markets Sovereign Debt
In this section, I will synthesize some recent research from Charles Schwab and Vanguard and attempt to pull it together to give readers an accurate picture of the risk/reward ratio of emerging market sovereign debt at this particular time.
Let’s get rid of the bad news first. This is my third time reviewing this particular ETF. The first was back on November 17, 2021 and the price stood at $77.42 per share. I came back for a second round of punishment on March 8, 2022, when I suggested emerging market bonds might be too cheap to ignore. At that time, the price stood at $69.45. In the meantime, this price dipped below $60 at one point, and as I write this, it has rallied back to around $64.50.
Why did all this happen? Take a look at the following two charts from Schwab Research, based on data from Bloomberg.
As can easily be seen, after a period of extreme weakness, the dollar has steadily appreciated against a basket of foreign currencies.
This is due to what Schwab calls a “trifecta of factors”. More specifically: 1) The relatively solid performance of the US economy, 2) The tightening of monetary policy by the Federal Reserve and 3) The purchase of safe haven securities.
Unsurprisingly, this combination of factors bodes particularly badly for emerging market currencies, a sample of which is shown in this next chart.
All of this, in turn, leads to challenges for emerging market debt, including sovereign debt. Why? Because this debt is denominated in US dollars. As these foreign currencies lose value against the dollar, these debts become more difficult to repay.
Is it any surprise, then, that VWOB has behaved the way it has over the past few months?
Let’s stay with the negative side of the story a bit longer. If you look at the first chart offered above, you will see that the tide has recently turned a bit. As the bond market appears to be pricing in a recession in our future, longer-term rates have fallen. Slower US economic growth could lead to a slower appreciation in the value of the dollar against other currencies.
At the same time, the other two factors in this trifecta, in particular the fact that the dollar remains a safe haven, would seem to imply that the strength of the dollar will not completely disappear anytime soon.
Given all of this, what might be the bullish case for emerging market sovereign debt?
For that, we turn to Vanguard Research. In the chart below, Vanguard suggests that, over long periods, this particular asset class exhibits an intriguing risk/reward profile.
As can be seen, the asset class sits almost on a straight line between the US Treasury and the S&P 500. Essentially, even though emerging market sovereign debt is technically bonds, their risk/reward profile is really somewhere between bonds and stocks.
Why might the risk/reward profile be particularly intriguing at this point? In short, because of the current price. You see, this particular asset class was one of the first to be affected by changing economic conditions. The emerging market sell-off began in late 2021 (ironically, just when I originally recommended it). As a result, it can be argued that it is already on the road to recovery, earlier than other asset classes.
Also, keep in mind that this is sovereign debt. While this is not without risk and defaults can and do happen, even then recovery rates are higher, as countries don’t completely disappear like businesses, and they have a strong incentive to repay their debt as much as possible, even in the worst circumstances.
Vanguard Emerging Markets Government Bond ETF – Digging In
While I won’t be rewriting everything I’ve written in my previous reviews, I’ll include a recap of some of the basic ETF details here, so you don’t have to read multiple articles for these details.
With regard to expenditure, on February 25, Vanguard announced expense ratio changes for 18 funds across multiple ETF and mutual fund equity classes, including a wide range of international strategies. One of these changes impacted VWOB, with the expense ratio dropping from 0.25% to 0.20%. Another “winner” for investors in this ETF!
VWOB seeks to track the performance of a benchmark index that measures the investment performance of US dollar-denominated bonds issued by governments and government-related issuers in emerging countries. The fund uses an index investing approach designed to track the performance of the Bloomberg USD Emerging Markets Government RIC Capped Index.
Here, from the fund legal prospectusis a slightly deeper dive into its exposition:
This index includes US dollar-denominated bonds that have maturities greater than one year and that have been issued by emerging market governments and government-related issuers. The Index is capped, meaning that its exposure to any particular bond issuer is limited to a maximum of 20% and its aggregate exposure to issuers that individually constitute 5% or more of the Index is limited to 48%. If the Index, as constructed on a market weight basis, exceeds the 20% or 48% limits, the excess is reallocated to bonds of other issuers represented in the Index.
With that, let’s get into some details related to the risk/reward analysis I proposed in the previous section. All graphics courtesy of Vanguard Investors Webpage for VWOB.
First, a high-level overview of the overall portfolio composition.
Needless to say, this ETF is an intriguing partner for any readers inclined to add a bit of BNDX to their portfolio after reading my last article.
Unlike an average coupon of 1.8% and yield to maturity of 3.9% for BNDX, the values here are about 2 times those amounts. Interestingly, while the average efficiency maturity is a bit longer in VWOB, on average duration is roughly the same as BNDX.
- NOTE: If you are unsure of the difference between maturity and durationI offer a pretty nice overview in this article from about 4 years ago.
It is therefore clear that if one wishes to include international bonds as an asset class in his portfolio, one can start with a base of BNDX and then “spice up” the level of dividend income by mixing the level of VWOB with which we feel comfortable.
Let’s continue with a look at geographic exposure. In the case of VWOB, since this is all Emerging Markets Sovereign Debt, I decided to grab enough of the chart to list the top 10 countries. Be aware that the full list can easily be seen on the Vanguard webpage.
Just a quick note here, courtesy of Vanguard:
Emerging market debt is much more diverse than it has ever been, with many new issuers on both sides of the credit spectrum. The category includes low-income countries in sub-Saharan Africa and rich oil exporters in the Persian Gulf. A more diversified issuer base translates into less idiosyncratic risk and more active management opportunities.
Then we move on to credit quality.
Here, to be clear, is where the level of risk to get that higher dividend yield increases. In BNDX, approximately 20% of debt is rated BBB or lower. In VWOB, this number is around 70%.
Finally, the effective distribution of maturities.
Just a comment on the approximately 28% of VWOB bonds with a maturity of 20 years or more. You might think of this as a kind of double-edged sword. On the one hand, this leads to greater volatility. On the other hand, emerging market debt yields can be very important as these longer maturities can support price appreciation as countries strive to improve their credit fundamentals.
Summary and conclusion
As always, I hope I have given you food for thought.
You may decide that a VWOB stipend is not for you, given the risks I have exposed. At the same time, please think about this word, allocation. It can be anything you are comfortable with.
Let’s even think about a conservative portfolio. What if you allocate a total of 3% to international bonds and split that between 2% BNDX and 1% VWOB?
In terms of diversification, you would broaden your horizons beyond the shores of the United States and reap dividends as well as a moderate potential for long-term gains.
I would love to hear your comments, questions, and even criticisms in the comments section below.