VWOB - VWOB: Emerging Markets Bond ETF Weak Investment Thesis

2023-08-23 21:06:51 ET

Summary

• VWOB is an emerging market government bond index ETF.
• It offers a growing 5.5% dividend yield, but very few advantages relative to peers.
• An overview of the fund follows.

I last covered the Vanguard Emerging Markets Government Bond ETF ( VWOB ) in mid-2022. In that article, I argued that VWOB's above-average dividends made the fund a particularly strong bond fund, and a buy. Since then, VWOB has outperformed most other bonds and bond sub-asset classes, due to suffering much lower capital losses, broadly in-line with expectations.

Lower capital losses also mean yields have remained stagnant in relation to most other bonds. VWOB compares somewhat unfavorably to most other fixed-income asset classes in most other fundamentals as well, especially senior loans and high-yield corporate bonds. As such, I would not be investing in the fund at the present time.

VWOB - Basics

• Investment Manager: Vanguard
• Underlying Index: Bloomberg Barclays USD Emerging Markets Government RIC Capped Index
• Expense Ratio: 0.20%
• Dividend Yield: 5.67%
• Total Returns (Inception): 2.29%

VWOB - Overview

VWOB is a dollar-denominated emerging market government bond index ETF. VWOB's underlying index includes all U.S. dollar-denominated bonds issued by emerging market governments, government agencies, and government-owned corporations. Applicable securities must also meet a basic set of inclusion and exclusion criteria. It is a market-capitalization weighted fund, with weight caps to ensure diversification.

VWOB provides investors with diversified exposure to the fund's investment niche, with investments in almost 700 bonds from dozens of countries, and hundreds of issuers. Concentration is quite low too, with no individual bond accounting for more than 1.0% of the fund's portfolio.

VWOB's diversified holdings decrease portfolio risk and volatility, and significantly reduce losses from the (potential) default of any one individual issuer.

Credit quality is somewhat below-average, with the fund investing in both investment-grade and high-yield bonds in roughly equal measure. VWOB does tilt investment-grade a bit.

For reference, most of the larger bond ETFs, including the Vanguard Total Bond Market Index Fund ETF Shares ( BND ), exclusively focus on investment-grade bonds:

VWOB's 5.7% dividend yield is on the higher end for a bond ETF, although a bit lower than benchmark high-yield corporate bond funds:

VWOB's dividends have grown 15.2% since early 2022, when the Fed started to hike. Although VWOB's holdings are not issued in the U.S., they are issued in U.S. dollars, so are significantly exposed to financial conditions in said country. Further growth is likely, as recent Fed hikes have not fully reverberated across financial markets, although much will depend on future Fed policy and broader market conditions.

As is the case for most bond ETFs, dividend yields somewhat underestimate the dividends investors can expect moving forward, as these are very backwards-looking metrics which do not (fully) take into consideration recent / prospective dividend hikes.

Annualizing the fund's latest monthly dividend payment nets me a 5.9% yield, slightly higher than the above. VWOB sports a yield to maturity of 7.2%, moderately higher as well. Both of these figures are much more indicative of the dividends investors can expect moving forward, at least assuming no significant changes to industry conditions or fund holdings.

Overall, VWOB seems like a reasonable investment opportunity, without any significant downsides. It does compare unfavorably to senior loans and high-yield corporate bonds on several key metrics, however. Let's have a look at these.

VWOB - Peer Comparison

Credit Quality and Volatility

VWOB has stronger credit quality than both senior loans and high-yield corporate bonds, due to the fund's significant investment-grade holdings:

Notwithstanding the above, in practice VWOB is of comparable volatility to most senior loan and high-yield bond funds, and sees comparable losses during downturns. As an example, the fund saw slightly higher losses than funds in these two asset classes during 1Q2020, the onset of the coronavirus pandemic.

Volatility is somewhat higher too, especially in comparison to senior loans.

VWOB's volatility and losses during downturns are both higher than expected because investors tend to perceive emerging market securities as particularly risky, credit ratings notwithstanding. Long-term, it is credit ratings, default rates, and fundamentals that matter, but short-term sentiment is key.

As an aside, I chose to compare VWOB with these two asset classes due to their comparable volatility. VWOB does have some benefits relative to, say, T-bills or long-term treasuries, but high-yield bonds and senior loans seemed like much closer peers.

Although VWOB's higher credit quality is something of a benefit and advantage for the fund, it seems to provide few practical benefits for investors. At least in the short-term.

Dividends and Yields

VWOB's dividends are lower than those of benchmark senior loan and high-yield corporate bond funds, on all relevant yield metrics.

VWOB's dividends have seen much lower growth too, especially in comparison to senior loans. As ETF dividends are very volatile these figures are not exact, but the difference is quite stark regardless.

VWOB's comparatively weak dividends are a key disadvantage relative to senior loan and high-yield corporate bond funds, especially considering the fund's above-average volatility. Very few reasons to choose a risky, low-yielding investment relative to a stabler, higher-yielding one.

VWOB's comparatively weak dividend growth also influenced my change in rating, from buy to neutral. Most bond funds have seen very strong growth since the Fed started to hike, VWOB's growth has been much weaker. This is true relative to high-yield bonds and senior loans, as seen above, as well as relative to most other bond sub-asset classes, as can be seen below.

Interest Rate Risk / Exposure

VWOB's holdings sport much higher average maturities and duration than both senior loans and high-yield corporate bond funds, meaning interest rate risk / exposure is much higher. This is particularly true relative to senior loans, as these securities have negligible interest rate risk.

Higher interest rate risk means higher losses when interest rates increase, as was the case in 2022, when Fed hikes started in earnest:

Corollary of the above is that VWOB should see higher share prices and total returns when interest rates decrease, as was the case from 2019 to 2020:

Importantly, lower Federal Reserve fund rates might not necessarily lead to higher capital gains and total returns for VWOB, for two reasons.

First, VWOB invests in emerging market bonds whose coupon rates are set by the market, not by the Fed. Federal Reserve policy does influence these securities, and quite heavily so, but prices are ultimately set by the market, and the market does not always blindly follow the Fed. Compare Fed rates with those of BBB-rated bonds, which account for 27.7% of VWOB's portfolio, and you'll see that there is definitely a positive relationship there most of the time, but not always.

Second reason why higher Fed rates might not necessarily lead to higher prices for VWOB, is the fact that the market has priced-in an aggressive set of rate cuts already .

VWOB's higher interest rate risk / exposure increases portfolio risk and volatility, but would mean higher share prices and returns if the Fed were to cut interest rates very aggressively in the coming months / years. In my opinion, this is a net negative for the fund, but more dovish investors might disagree.

Performance Track-Record

VWOB's overall performance track-record is quite poor, with the fund underperforming senior loans and high-yield bonds since inception, and for most relevant time periods:

Although the figures above are accurate, I think they overstate VWOB's underperformance. There are periods of time during which the fund has outperformed, including a long stretch from early 2014 to early 2020:

On the other hand, almost all of that outperformance occurred in 2016, a single year. VWOB did not consistently outperform during the time period above, just a couple of times.

Still, the overall performance track-record is quite poor, with the fund generally underperforming its peers.

Comparison Takeaway

In my opinion, although VWOB does have some advantages relative to senior loans and high-yield corporate bonds, it is overall a much weaker choice.

VWOB is more volatile, yields less, has a weaker performance track-record, and has seen weaker dividend growth during the current hiking cycle. In exchange, credit quality is stronger, but this is not reflected in the fund's performance, and the fund could see much stronger gains if the Fed were to aggressively cut rates. In my opinion, this is not a compelling trade-off, but more dovish investors might disagree.

Conclusion

VWOB offers investors diversified exposure to dollar-denominated emerging market government bonds, and sports a good, growing 5.7% dividend yield. Although there is nothing inherently wrong with the fund itself, it compares somewhat unfavorably to most high-yield corporate bond ETFs on most relevant metrics. As such, I would not be investing in the fund at the present time.

For further details see: