Vanguard International Bond Fund

Thanks to the reader who emailed me about Vanguard's announcement that their international bond fund will finally be launching in the second quarter of this year.

The fund, in the making for over a year, will invest in investment-grade fixed-income securities from all over the world, both government and corporate issues. In practice the fund will be concentrated in foreign developed nations with Japan, Germany, France, and UK securities combining to make up just over half the fund's holdings. More details about the holdings will presumably be forthcoming from Vanguard.

The new fund has a fairly reasonable expense ratio of 0.20% for ETF and Admiral version of the mutual fund, and 0.23% for Investor version of mutual fund. There's also a 0.12% Institutional version if you have $5 million to throw at this investment.

The fund is currency-hedged. That means that the fund's returns will roughly be the same as the returns of the underlying bonds in their native currencies -- as opposed to being influenced by ever-changing foreign exchange rates between the native currency and the US dollar. This is both good and bad. It's good in that the returns and volatility of this fund would resemble the returns and volatility of a US dollar-denominated bond fund. It's bad in that currency hedging will necessarily add some frictional costs (which are almost certainly not accounted for in the headline expense ratio) and in that potential currency diversification benefit will not be present. Extra costs would concern me more than lack of currency diversification here, though they should be small.

Overall it's probably good that Vanguard is offering this product, just to have a low-cost, index-based investment in this space. But my hunch is that at least right now this fund is not in any way a must-have investment. Currency hedging greatly reduces investor's chances of benefiting from higher-yielding foreign bonds, as I explain in http://www.longtermreturns.com/2013/01/foreign-bonds-with-currency-hedging.html . More to the point,  actual holdings of this fund -- at least the four biggies we know about in Japan, Germany, France, and UK government bonds -- have yields that are similar to or lower than equivalent US securities. Japan's 10-year government bonds yield whopping 1.2% less than US 10-year treasuries. Germany's yield 0.3% less. UK's yield only 0.1% more. France's yield 0.3% more. We'll have to wait to get more details from Vanguard, but at least on the government issues it's hard to expect this bond to out-yield what's available domestically. Very cursory examination of available international corporate bond funds leads to me to believe the same will be true there as well. And remember -- all of this is before expenses, which will be higher for the international bond fund, both in headline ratio and in hidden frictional costs.

So, in internet parlance: meh. This fund is shaping up to have returns every bit as pedestrian as Vanguard's Total (domestic) Bond Market fund VBMFX (ETF version: BND) but with marginally higher expenses and, arguably, with higher risk. How many of you are itching to lend money to Japan's government whose debt is already twice the size of US government's debt relative to the GDP and which pays under 1.0% in interest (even before those frictional costs)? And this gem will almost certainly be the largest single holding of the new fund, likely in 15% range!

What I am most unhappy about is not the design or holdings of the new fund, but that Vanguard has already decided to incorporate it in all of its asset allocation investments: LifeStrategy funds, Target Retirement Funds, and the managed payout funds. 20% of fixed income holdings of these funds will be allocated to the new international bond fund. I am not upset because I think this decision will lead to big losses to investors -- actual losses will be miniscule and may even turn out to be gains (though I doubt it). It's the principle of not messing with what is, at least implicitly, sold as a set-it-and-forget it investment.

Whatever happened to staying the course? Will Vanguard decide in a few years that real-estate investments are vastly under-represented in its funds relative to the US economy and add a dollop of US REITs? And a couple years later realize that global real estate is also under-invested and throw in international REITs? And maybe later they'll decide to hop on the small/value bandwagon? This just sets a bad precedent. Though "precedent" is probably the wrong word, since Vanguard has done this before, changing the amount of international equities held by its Target Retirment funds. Other fund companies are guilty of the same.

This will cause me to rethink my recommendation of LifeStrategy funds going forward. I saw them as nearly perfect stay-the-course investments. Now it has become obvious that Vanguard will keep tinkering with them as it "discovers" new must-own investments.

[Quick note about another reader email I received asking about long-term care planning... This subject is very important but I just don't have the expertise on the issues involved. I am learning and if and when I feel that I have something worthwhile to say on that subject I will definitely make a post.]