2023-09-29 07:00:00 ET
Summary
- Vanguard Total World Bond ETF offers exposure to investment-grade bonds worldwide, but its yield is diluted by low bond yields in many countries.
- The fund's American bonds have higher yields than its foreign bonds, making the US version of the fund a better option for higher yields.
- The global economy is slowing down, which could lead to a global recession and make international bonds even less attractive for American investors.
- Alternatively, foreign stocks now have higher yields than many foreign bonds, so investors could also look at those for income.
Vanguard Total World Bond ETF (BNDW) is a highly popular product by Vanguard which allows investors to gain exposure to thousands of "investment grade" bonds (meaning no junk bonds) across the world. Bond investors seem to really like this product but I am inclined to not recommend this fund as a buy because its yield is diluted by its exposure to many countries where bond yields are still too low.
Fund's assets are divided 50%-50% between US bonds and bonds originating in other countries. My main problem with this fund is that the fund's American bonds have yields around 4-5% while its foreign bonds have much lower yields, giving the fund a dividend yield of 2.7% (based on the last monthly distribution). Investors would be better off just buying the US version of this fund also owned and managed by Vanguard (BND) which will sustain higher yields.
In the last year and half, the Federal Reserve has been raising interest rates in a very aggressive manner, hiking them from 0% to 5.5% which is one of the quickest rate hike cycles in history. Central banks around the world also started hiking rates but not nearly as fast as their American counterpart. For example, Bank of Japan is still keeping Japanese rates near zero and China's rates are below 3.5%. Switzerland is enjoying rates below 2% and Australia's rates barely reached 4% recently. Euro Zone was late to the party of hiking rates and currently enjoys rates of 4.5%. Keep in mind that countries within Euro Zone have their own rates which may be different than the zone's own rate. For example, Germany's long term interest rate is 2.5%.
When we look at this fund's holdings by country, the biggest country after the US is Japan followed by European countries. This is having a diluting effect on the yield where investors would be better off just buying American bonds and maximize their risk-free yield.
In many parts of the world the economy is slowing down significantly partially as a result of these rate hikes. As central banks around the world hiked rates as a response to rising inflation, they already knew that this would have slowing effects on the economy. For example , Euro Area industrial production dropped -2.2% from last year which signified contraction for the 5th month in a row while durable goods production dropped for the 4th month in a row.
We are also seeing signs of slowdown in Asian economies, including that of China and Japan. If global economy slows down enough, this could lead to a global recession which could mean that we won't see more rate hikes. If anything, we might see some rate cuts. In fact, China already made such move last month even though it was on a small scale. This could make international bonds even less attractive for American investors since the average yield of foreign bonds is likely to drop in comparison on American bonds even though their risk profiles might be similar.
Having said that, if global central banks hold interest rates higher or hike them even further, there is reason to believe that this fund's yield could actually rise. Currently, the fund's average coupon rate is 2.6% but its yield to maturity is almost twice that at 5.1%. As the fund's bond holdings start maturing and the fund starts reinvesting those into new bonds, its yield is likely to keep increasing but it's going to happen slowly over long period of time considering the fund's average effective maturity being 8.8 years. By then it is also possible or even likely that interest rates won't be as high as today considering their historical averages so this yield might never actually materialize for holders of this fund. Also considering that the fund's turnover rate is only 13%, it's going to take quite a while for it to realize benefits of that fat yield-to-maturity rate.
Investors can have better yields from American bond funds for the time being as long as the Fed keeps rates at or above current values. In fact, even if the Fed suddenly cut rates from 5.5% to 0% for whatever reason, bond investors could still come ahead since they would see massive price appreciation especially if they are holding longer term bonds. The longer duration of a bond is, the more price fluctuation you get because of rate fluctuations so the relationship between maturity period and rate sensitivity is a strong and positive one.
Of course my thesis is only looking at it from a purely income perspective. If we are looking at total returns, American bonds and global bonds (which still also include American bonds) had similar performance in the last 5 years. If your goal is "total return" you would rather be in stocks anyways. Bonds are mostly there for income generation purposes and they will almost always underperform stocks in the long run.
Here is the interesting thing, Vanguard Total International Stock Index Fund ETF ( VXUS ) has a distribution yield of 3.2% which is higher than this fund's distributions yield. This is telling us that foreign stocks are probably cheaper than foreign bonds. In the US we have the inverse relationship where bonds yield 5.5% while stocks only yield 1.6% ( SPY ) so stocks are far more expensive in the US as compared to bonds but we are not necessarily seeing it in foreign markets. Maybe investors who want international income exposure could look at foreign stocks instead of foreign bonds.
For further details see:
BNDW: Its Yield Is Getting Diluted By Its Country Mix