Good international bond fund for long-term investing?

by philg

I spoke with a certified financial planner at Vanguard last week. For security in the event of a U.S. stock market meltdown, he recommended holding some bonds via a fund. Which fund? One that invests exclusively in U.S. municipal bonds. That’s right, the folks that have signed up for pension and retiree health care obligations that they can’t even understand, much less pay (the shortfall is supposedly around $3 trillion, but since nobody knows how long people will live or how much health care will cost in the future, it could be much more). Also, in many cases, these are the bonds of sovereign entities that can default without leaving investors any recourse in federal courts (see this Brookings Institution article). Finally, given enough inflation in the U.S., these bonds would be paid back in “mini-dollars”.

The idea of California bonds as a hedge against the risk of a collapse in the price of Intel strikes me as a poor one. Would an investor be better off with a mixture of bonds from different economies worldwide and in different currencies? I’d feel a lot more comfortable holding bonds from Germany than from the city of Chicago. If the U.S. government’s money printing operation generates out of control inflation, it would be much nicer to be paid in Australian dollars (now worth more than the U.S. dollar, for the first time since 1983, when the currency began to trade freely) than in U.S. mini-dollars. And if the world muddles through more or less unchanged… the currency variations should average out to null and the interest rates on those foreign bonds should also be about the same as on dollar bonds.

One potential disadvantage to this plan is that foreign bonds don’t get the tax exemption on interest that U.S. municipal bonds get. Perhaps the sophisticated investor would buy the municipal bonds and insure them against default (and hope that, in the next crisis, whoever succeeds AIG as the biggest bond insurer also gets bailed out with money from the suckers (i.e., taxpayers)).

Another disadvantage seems to be high fees, in the neighborhood of 0.5% per year. The yield on a 10-year German bond is 3.14% (Pi, as far as a computer scientist is concerned), so fully 1/6th of the return goes to a manager. The expense ratio on a typical Vanguard bond fund is around 0.12%.

Does anyone have specific funds to recommend? Or perhaps a strategy of simply buying individual long-term bonds and holding them? (I have to believe that the trading fees for an individual buying a foreign bond are going to be much higher than what a fund would pay.)

34 thoughts on “Good international bond fund for long-term investing?”

  2. Phil,

    if it’s German bonds you’re after, see

    http://www.deutsche-finanzagentur.de/en/private-investors/german-government-securities/

    The “Finanzagentur” offers free accounts for German bonds to private investors. I have no idea if that also works for foreign investors – since they have some English web pages, I assume that it does, but it looks like you’ll have to come to Germany at least to open the account.

    “Free” in this case really means free. There is no management fee, and investors can even buy some types of bond directly without brokerage fees. The ten-year bonds (“Bunds” in the lingo, I think) are traded on exchanges only, as far as I know, so there would be a brokerage fee for buying them, but once they are in the Finanzagentur account, there are no additional fees.

    Cheers

    Helge

  3. Brad: I don’t think the “you make dollars; you spend dollars” idea is sufficient for the long-term. For one thing, I don’t spend only dollars. I spend yuan and yen since much of what I buy is made in China or Japan. If I buy oil to heat the house or power a vehicle, the price will be set by worldwide demand. Being a millionaire in dollars isn’t so great if USD$1 million is the price of a Chinese-made television.

    Look at what happened to Argentina, which was once considered to have excellent long-term economic prospects. A lot of the smart young people emigrated to foreign countries for career opportunity. The parents who had a lot of investments in Euros and U.S. dollars were much better able to follow their kids than parents who were only invested in Argentine stocks and bonds.

  5. RE: “you make dollars; you spend dollars”

    usually what happens with a weaker dollar is that you will see price inflation, i.e. goods imported from foreign countries would cost more.

    so if you are worried about inflation, then go for inflation-linked bonds.

    RE: Look at what happened to Argentina
    Let’s say you are worried about US going Argentina, so you invest in Euros and Yen. The Euro and Yen may go Argentina too. so where does that leave you?

  7. Have you consider emerging market bond funds as another means of diversification? FNMIX has a pretty good track record, expenses are higher, but still lower than average for that category

  8. Phil,

    I’m glad you asked this, because I’ve had the same issue. I use a lot of Scott Burns’ investment philosophies, and some of his “Couch Potato” sample portfolios (http://assetbuilder.com/blogs/scott_burns/archive/2010/04/02/building-index-fund-portfolios-on-different-platforms.aspx) have international bond funds in them. But I’ve found high fees on everything available to me (this is all 401k money).

    Aside from what’s available, I’m getting scared of investing in European bonds anyway due to the recent problems in Greece and the possible upcoming problems in Spain and Ireland. Since it’s the EU, richer countries like Germany will likely be bailing out poorer (or worse run) countries like Spain and Ireland. The sovereign countries cannot simply print Euros to pay debts, like the US government can. They are more like states, I suppose, in this case.

    So, I’m still investing in TIPS. Not great, but I’m pretty sure I’ll get my money. If I don’t, I’ll probably have bigger problems, like the Chinese soldiers marching down my street.

  9. Brad: How can you say the US is the best sovereign debt when, by many account, we’re already hopelessly bankrupt when you consider unfunded liabilities? We’re like a company that’s losing money hand over fist, but nobody knows it yet because we’re deferring our costs to future quarters but taking earnings now. There’s a guy at BU (I wish I could remember his name) that estimates the current value of our TRUE liabilities, when extended out to 2080, at something in the hundreds of trillions. According to him, and many others, when you consider the ludicrous entitlement payments the US has promised future generations, we’re far worse off than even Greece.

    I’ll take Bunds.

  10. Brad: One more thing. I’ll second Phil’s comment about “you make; you spend” arguments. The whole gig is predicated on China continuing to screw over its own citizens for our benefit, holding down their wages by funding our consumption (the two are intertwined because they devalue the Yuan by buying our government debt, and then our government uses that cash to placate us with the illusion of a functioning economy purchased via government contracts with China’s money). How long do you think that’s going to last? My guess is “only as long as they need to to beat us.”

    We, as a country, survived a revolutionary war with a global superpower, civil war, countless “conflicts”, two world wars, a nuclear cold war with another superpower, but at the end of the day China is going to beat us without firing a single bullet, using nothing more than our own greed and cupidity.

  11. If you want German bond funds (some great Greek and Irish debt exposure via their banks – that’s how they support their manufacturing exposure, by lending others the money)
    there are now some etfs eg: BWX and WIP (inflation protected Int. bond etf). The volume traded is not great, and they are not as big as the mutuals but the expense is 1/4-1/3.

    If you want to speculate/”hedge” on currency you can do that easily with popular etfs (FXA for australian… and yes they pay interest if you are interested, also something like everbank.com has foreign currency accounts)

    But this idea that muni funds are in such danger is way way overblown. There have been almost no defaults by any public entity since mid 1800’s the ones that have defaulted recovered over 99% and most of the “muni” issuers that did default were
    tax-free non-public issuers like hospitals or projects. (Did you know that GE can issue tax-free on occasion and can wind up in a “muni” fund.)
    Besides history- the issued debt burden of most states is quite small, and the covenants usually place it very high on obligations list. So, it makes no sense to default on it then the savings aren’t there – they will more likely cut retiree medical costs: those are far lower among obligations. As far as “insurance against default” – if you mean CDS on munis – forget about it, there’s almost no market, it’s very specific situations. But many munis are “wrapped” with various guarantees by major banks when they are sold, otherwise the market wouldn’t be quite so big.
    All this said – if you’re really worried about a US market meltdown, muni fund is not likely a great hedge, neither is Intel and very likely neither is an Australian or European fund.

  12. Chao: I would be happy to have a basket of bonds from all of the world’s countries, including what Wall Street calls “emerging markets” (China is still considered emerging though their economy is now larger than Japan’s!).

    Regarding the helpful TIPS suggestion… the U.S. CPI doesn’t seem to work for me, except maybe when I’m buying peanut butter at Costco. The things that I actually spend significant money on seem to go up at a much faster rate than the official CPI.

    Regarding the idea that “the U.S. is still the greatest country in the world and our bonds are the best”… I already have a huge amount of exposure to the U.S. economy and market. If my investments went to zero and the U.S. economy were booming, I could always just get a job. If I need to rely on the bonds, it means that something has gone badly wrong with the U.S. economy and therefore U.S. bonds, even Treasuries, seem like a poor choice.

  14. Dino: Thanks for the suggestion. “Management costs are low” you say? And that’s because it is an ETF? The Web page says “management fees 0.60%”. That’s five times as high as Vanguard’s fee for domestic bond funds. It’s more than twice as high as the 0.27% fee for the Vanguard emerging markets equity fund. Right now your fund’s yield is 5.13%, so the managers are helping themselves to 1/8th of your return. That seems like a lot, considering that all they are trying to do is track an index.

    [Maybe the answer to this question is “If you want to make money, don’t invest in a fund, START a fund and then charge other people 0.6% annual fees.”]

  17. Isn’t it a bit late to be thinking about this? USD has already dropped 30-40% against resource-backed currencies, so you’re realizing your loss by moving dollars into most foreign debt.

    Best bet may be to wait for a USD bounce on the next market crash (risk-averse institutions still prefer our dollar for short-term holdings) then look at Brazilian bond funds.

  18. Assuming you have a sizable equity allocation, I feel it is sufficient to globally diversify your equities and stick to domestic bonds. You could even overweight non-US equities to compensate for the domestic bonds. If your portfolio is mostly bonds, then diversifying into non-US bonds would be more important.

    In a taxable account, the tax advantages of muni bonds will likely outweigh the diversification benefit of non-US bonds. In a tax-advantaged account, I agree that a high-quality, unhedged, inexpensive non-US bond fund would be a nice diversifier. BWZ, IGOV, and ISHG are fairly inexpensive with 0.35% expense ratios.

    The historical default rate on high-quality munis has been very low: http://en.wikipedia.org/wiki/Municipal_bond#Default_rates. Of course, past performance is no guarantee of future results.

    Lots more discussion of intl bonds on the Bogleheads forum: http://www.google.com/search?q=international+bonds&sitesearch=bogleheads.org

  19. If you are worried about US going Argentina, then I’d suggest safe heaven assets such as swiss francs, precious metals and real estate in OECD countries.

    won’t make you a lot of money, it’s really a hedge.

  20. Phil: you are right, my suggestion is not chip, however, you are comparing costs of funds of different categories. The Vanguard collects EM stocks, the JPMorgan, EM bonds. (As far as I can tell, buying/selling “raw” bonds is more expensive than stocks, in general.) However, the JPMorgan is not expensive either, being the category average 0.55. Keeping in mind that the JPMorgan is paying dividends, I still think this is a fair choice, IF you want to invest in EM bonds. Also, some folks do not like dividends because you end up paying more taxes; so there is probably out there an EM bond tracker that doesn’t pay dividends and has lower costs.

  21. M: “the historical default rate on high-quality munis has been very low”. I have several concerns with this. The first is that “high-quality” is defined by the same ratings agencies that rated mortgage-backed securities AAA. And if I’m not mistaken, these agencies, e.g., Moody’s, are still paid by issuers, so the same conflict of interest that contributed to the Collapse of 2008 remains in place. (See http://philip.greenspun.com/book-reviews/it-takes-a-pillage for more on this.)

    A deeper concern is that I don’t think a municipality or state needs a history of default in order how to default; it simply needs to go broke. “When States Default: 2011, Meet 1841” (WSJ, January 4, 2011) talks about the default of eight states plus Florida (then a territory) in 1841. They didn’t have public employee pension and health care obligations back then, but they still managed to default. The default led to the institution of new property taxes or an 8X increase in tax rates, which I don’t think would be workable today. Could an average homeowner in New Jersey pay $56,000 per year in property tax (up from $7,000 in 2009)? If you read While America Aged you’ll see that the public employee union-politician-pension cycle did not get started until around 1960. U.S. states and cities are in an entirely new environment, having made pension and health care guarantees to people retiring as young as 41 and living to more than 110. If you assume that very few public employees were old enough until 1985 to soak up the big pensions that started being guaranteed by union-backed politicians back in the 1960s, the only history that matters is 1985 to the present. This is the first big economic slowdown since 1985 and we don’t know what the consequences will be.

    Why wouldn’t it be better to have bonds from a non-broke country, such as Australia? Purely because of the tax break for munis? Perhaps the answer is a fund that somehow reinvests the bond payments from international bonds and thus converts them into capital gains when the fund is eventually sold (Dino alludes to this possibility with his “EM bond tracker” idea).

    State constitutions often guarantee public employee pensions. So by buying a muni bond you’re lending money to an entity that is already broke and you’re signing up to be second in line to be paid.

    Remember… I’m not saying that state and local governments will default, only that the very circumstances that push down U.S. stocks will make it more likely that they default. The biggest obligation of state/local government is pensions. They’re budgeting approximately 8% return on investment from mostly stocks (and mostly U.S. stocks). If stocks go down, i.e., the very scenario that would make the rest of my portfolio likely to go down, state and local governments will owe many trillions of dollars beyond the $3 trillion that they’re supposedly already short. At the same time, given a big market crash, the U.S. economy will be stagnant or declining, reducing state and local tax bases. So why not buy a bond from an entity that is not so exposed to the risks of a U.S. stock market decline?

  22. Hey Phil,

    I just wanted to let you know that I have the very same concerns as you with regard to a crash and its subsequent effects on state/local defaults. Whenever I talk about it with anyone though, they sort of look at me like I’m an insane person.

    States never default and housing prices never go down! Never!

  23. Thanks, Jay. I’m not digging a shelter, hoarding gold, and peering out through the scope of my AR-15. It is just that, especially in light to my existing exposure to the U.S. economy through stocks, if the government of Australia says “give me $100 and I’ll give you back $1.20 in five years” I would rather take that than the state of California’s offer to give me back $1.21 or $1.19.

  24. Phil, you can try to hedge all kinds of risks, but that comes at a cost both financial and ultimately in lifestyle. You usually advocate for people to move if they can’t find a job – if you prefer the financial position of other countries, you can pick up and move to Germany, Australia, Canada, Switzerland or Caribbean. Each is going to be an interesting choice (you can save on taxes, enjoy well-made products, fine design, orderly society, good healthcare, nice weather, ocean, mountains, familiar language, proximity to Boston, no taxes… but alas not all at the same time). Most other western countries have a heavier tax burden than U.S.’s (federal) 24% or so. (Denmark is a very nice country but theirs is about 50%). (http://www.oecd.org/document/60/0,3746,en_2649_34897_1942460_1_1_1_1,00.html#A_RevenueStatistics)
    There are creative financial instruments too, Cat(astrophe) bonds, Life insurance securities. Alternatively, for a total meltdown in financial markets, I might suggest a hedge along the lines of Gold in a safe deposit box (Canadian bank of course) or buried… (buried where? on the other leg of this hedge – a plot of farmland, look for something with a nice water source)

    Back to Muni’s (still not advocating as a big bang hedge against economic meltdown). In Mass. the debt service was 6.2% of Revenues in 2010 (http://www.mass.gov/Aosc/docs/reports_audits/CAFR/CAFR_2010.pdf). GO bonds have statutory protection as well (They are not second in line – defaults, which are usually technical like cashflow timing, are addressed by a judge in court or settled out of court, States are sovereign under US constitution and are not covered by bankruptcy, a budget deficit is addressed by raising taxes or cutting expenses). Most muni’s are not GO they are revenue bonds for specific projects like a toll road, or conduits for hospitals or real estate development. They come with credit enhancements, different tax treatments (AMT), etc. They are indeed quite safe if complex and heterogeneous. Just look over the holdings, consider your tax situation and relative return.

    I guarantee, as soon as you start buying up german or australian bonds you will start fretting about their export reliance on periphery EU countries (GE) or China/commodities (AU), their energy dependence on Russia(GE), their account deficits in foreign currency(AU), their banking sectors financing irish/american/spanish MBS and not accounting for losses (GE), or reliance on wholesale funding and project finance(AU), and so on.

  26. Phil – I think your expectations on expense ratios are a bit high. DFA has a pair of foreign-flavored (evidently they still hold US government securities) bond funds that have an expense ratio of .30%. All other world bond mutual funds have expense ratios of well over .5% – and some are really absurd. Unfortunately getting single basis point expense ratios out of this asset class does not look possible.

    On the ETF side, there are a pair of iShares funds, IGOV and ISHG, that have expense ratios of .35% and invest in mostly developed countries: “As of May 31, 2010, the Underlying Index included securities issued by governments in the following 19 countries: Australia, Austria, Belgium, Canada,Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.” The underlying index is heavily skewed toward Japan, and its choice of weighting Italy nearly as much as Germany, and Greece equally with Canada are rather questionable.

  27. Phil, I’m strongly considering buying these, having the same objectives as you, although I’m also considering insured munis:

    VPL
    VGK

  29. >>I would be happy to have a basket of bonds from all of the world’s countries, including what Wall Street calls “emerging markets” (China is still considered emerging though their economy is now larger than Japan’s!).<<

    Not sure if it was suggested above, but Vanguard's Total Bond Market ETF (symbol: TBM) might be the perfect solution. Ultra low fees at 0.12% and exposure to bonds across the globe.

    john

  30. John: Thanks for the Vanguard Total Bond Market suggestion. The Web site says that just 5 percent of their holdings are “foreign”.

  31. Sorry…got the symbol wrong. Its “BND”

    Lots of international exposure, though it would include substantial US holdings as well.

  32. Phil,

    If you are looking for international bond exposure, your first questions to ask are:

    * Do I want exposure to sovereign issues, or corporate issues, or both? (do you really want a bunch of government bonds denominated in the Euro?)
    * Do I want developed markets or emerging markets exposure? (the emerging markets countries have much better debt/deficit pictures than the developed nations do)
    * Do I want my currency hedged or unhedged? (For your thesis, you would want unhedged)

    Keep those questions in mind, and give these funds a look:

    * PIMCO Foreign Bond (PFUIX)
    * Loomis Sayles Global Bond (LSGLX)
    * DoubleLine Emerging Markets Bond (DLENX)

    Worth asking, though — if your thesis is that the US is printing so much money as to shrink the value of the dollar, are there better hedges? Foreign bonds would certainly be an important part of a portfolio to protect against monetary inflation, but so would:

    * Precious metals
    * Commodities
    * Real Estate (non-US)
    * US TIPS
    * Global “Linkers” (like TIPS)

    For what it’s worth.

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