The Debt Problem in Bond ETFs

This article was written for www.etfmarketpro.com

International bond ETFs are an asset we can no longer ignore, but as some industry experts have brought up in the past, bond ETF construction has many inherent flaws.

The construction flaws in ETFs often stem from the methodology of the indexes which the ETFs track. Bond indexes use a method similar to market cap weighting, sometimes called market value weighted, in which bonds are weighted by debt outstanding, rewarding companies and countries that have more debt with a higher percentage of the index’s allocation.

Below is a chart of the growth in the iShares Barclays Aggregate Bond Fund (AGG) compared to the two international Treasury bond funds,  iShares, S&P/Citi International Treasury Bond (IGOV) and SPDR Barclays Capital International Treasury Bond (BWX), 1/23/2009 through 11/15/2009 (Source: Morningstar Office).

As the chart shows, there’s been significant growth in the international bond funds, with a AA rating for both the international funds. This outperformance is mostly due to the favorable change in the dollar relative to other currencies.

The low correlation and ability to capture returns from a falling dollar inside of a fixed income product can be extremely beneficial when investors want exposure to international markets, but are wary of the potential risks from overexposure to international stock markets.

Structural Risks In Bond ETFs

As discussed above, bond ETFs weight by the amount of debt outstanding, and this applies on a country level for these international Treasury bond ETFs. When looking at international debt market indexes, we notice a significant slanting towards Japan, because the large amount of debt the country holds.

As shown in the graph, Japan makes up large percentages in both ETFs and The SPDR Barclays Capital International Treasury Bond (BWX). Italy also has a large holding. Because of the diversification rules for the funds, any country weight is capped at 24.95% and the bond ETFs are rebalanced monthly to maintain the country exposure, set annually in March.

These two bond funds represent the developed international treasury market as determined by debt amounts. Countries with higher debt levels are given higher allocations. This is a risk, since countries with larger liabilities have more risk and a higher chance of defaulting on those bonds, despite the low probability of that actually occurring.

Investors are compensated for the extra risk they carry. Currently, The SPDR Barclays Capital International Treasury Bond (BWX) has an average coupon of 4.32%, as of 10/31/2009. The iShares S&P/Citi International Treasury Bond (IGOV) has an average coupon of 3.85%, as of 11/11/2009. For a comparison, a US intermediate Treasury benchmark ETF, iShares Barclays 3-7 Year Treasury Bond (IEI), has an average coupon of 3.58% as of 11/11/2009.  Keep in mind that the international Bond ETFs have seen large returns this year, which has pushed down yields. The iShares S&P/Citi International Treasury Bond (IGOV) has risen 13.02 in the last six months, ending 10/31/2009, and The SPDR Barclays Capital International Treasury Bond (BWX) has returned 12.68% during that same time period. Meanwhile, US Treasury ETF, iShares Barclays 3-7 Year Treasury Bond (IEI), has returned 0.70% in those last six months (Source: Morningstar Office).

When analyzing bond ETFs, it is important to consider the diversification and allocations of the underlying indexes and where the fund’s risks may be. The international developed treasury asset class has many aspects that would be a powerful addition to a portfolio, giving access to profiting from a falling dollar with less volatility than would be present in international stock portfolios, all while providing income and low correlation to US bond sectors.