Should You Buy Vanguard’s New International Bond Index Funds?

I’m a bit late to the party, but Vanguard has recently announced that it will launch two new international bond index funds: a Total International Bond Index Fund and an Emerging Markets Government Bond Index Fund. I’m a fan of diversification in general (and hence alternative asset classes like foreign bonds in particular), but I’m not entirely sure I will be buying these international bond index funds anytime soon for reasons I’ll discuss in a bit.

Should You Own These New International Bond Index Funds?

There are some compelling reasons to own international bonds. However, since these two funds are very, very different they should be evaluated separately. One important consideration is that both of these funds are partially hedged against currency fluctuations. So far so good. Hedging isn’t free, however, so those hedging costs can reasonably be considered an additional cost of owning this asset class, just like costs like taxes, brokerage commissions, bid/ask spreads, etc. Note that hedging costs, like those mentioned above, are not reflected in a fund’s expense ratio. I’m not sure if this additional cost is significant, but it’s not zero, so buyer beware.

Total International Bond Index Fund

Jack Bogle was for years an adamantly opposed to international bonds (although he has now reportedly changed his mind). Many investors however, especially slice ‘n dice investors like me, consider foreign bonds to be an asset class unto itself, just like international stocks and small-cap value stocks. It seems like Vanguard has now come along to this point of view.

In a study published earlier this year, Vanguard came out in saying allocating between 20-40% of your total bond allocation to foreign bond funds yielded modest but not-insignificant diversification benefits. For investors willing to accept slightly higher costs, this new Total International Bond Index Fund seems like the ideal way to gain foreign bond exposure. It is broadly diversified (holding over 7,000 bonds from all over the world), very inexpensive (relative to its peers), and only moderately correlated with the domestic bond market (albeit this is based on very limited data).

This fund deserves serious consideration from slice ‘n dice investors; however, the vast majority of individual investors probably needn’t bother. International bonds almost certainly fall into the “nice to have” and not “got to have” category.

Fund Expenses:
Investor Shares: 0.40%
Admiral Shares: 0.30%
ETF: 0.30%

Emerging Markets Government Bond Index Fund

Emerging market sovereign debt is a different animal. Emerging market bonds can be quite volatile: far more volatile than what most people would expect when they think of bonds. In that regard, they probably have more in common with junk bonds than any other asset class.

I’m going to go out on a limb and say 99% of investors should not own this fund. Very sophisticated investors with large portfolios will probably benefit from the additional diversification benefit emerging market bonds can provide, but most of us just don’t have large enough portfolios to justify slicing and dicing our portfolios down into such small market segments.

That said, the fun does have a few pros. It is extraordinarily inexpensive for an emerging market debt fund, and the fact that it’s run by Vanguard means it will probably stick to the more highly-rated segment of that particular market. Still, the rewards don’t seem to outweigh the risks of owning this asset class, at least not for investors of modest means. Then again, I’m not bond expert so I reserve the right to change my mind later.

Fund Expenses:
Investor Shares: 0.50%
Admiral Shares: 0.35%
ETF: 0.35%

I Intend To Buy The Total International Bond Index Fund…Eventually

(Here’s Why You Should Wait Too)

I fully intend to diversify into international bonds in the future. I think they are a good secondary asset class to own and will probably be a moderately-effective diversifier. I don’t think I will buy them anytime soon, however, and my reasons are actually fairly similar to those of Mike Piper over at Oblivious Investor.

1. Bonds only make up 10% of my portfolio – Since bonds comprise such a small part of my portfolio, there really isn’t that much practical benefit to subdividing them further. Any diversification benefit gained by allocating half my bonds overseas would be totally insignificant in the context of my overall portfolio. Were bonds to make up 30% or 40% of my portfolio, I would almost certainly own the Total International Bond Index Fund.
2. Diversifying into TIPS is a higher priority – While I like international bonds, I like TIPS even more. I think TIPS give more bang for the diversification buck, so to speak. When I increase my bond allocation from 10% to 20% in a couple of years, I’m going to allocate that additional 10% to TIPS and not foreign bonds. As my bond allocation (and account balance) grows over the years, I will begin easing into international bonds. But not until my account balance justifies such a move.
3. The expenses will come down – Vanguard is very good at regularly lowering the expense ratios on its funds as they grow. While 0.40-50% isn’t that much compared to the rest of the industry, it’s quite high compared to the average Vanguard fund. I fully expect the expense ratios on these funds to come down significantly as they attract assets.
4. We don’t REALLY know how correlated to domestic bonds they will be – Foreign bonds have been only moderately correlated with domestic bonds in the past; however, they have also never been easier or cheaper to own than they are right now with the introduction of these new funds. As more investors diversify into this asset class, correlations could rise. Additionally, we have limited data to begin with, so future correlations could be higher (and diversification benefits lower) than we expect. Again, there’s no rush!