Saturday, April 07, 2012

Researching Foreign Bond Funds (ETF's)

Over at Trust Funds for Kids I wrote a long article on researching foreign bond funds (ETF's). If you are interested read more below the fold. Recently I have been evaluating my total portfolio in terms of US dollar exposure.

Traditional (primitive) metrics of portfolio evaluation picked concepts like
  1. Splitting your portfolio between cash / bonds / stocks / real estate
  2. Splitting your stock portion between US and foreign stocks
  3. Breaking down your stock exposure into industry sectors like technology, finance, consumer products, etc...
  4. Adding a category for commodities, generally broken down between the precious metals (particularly gold, which had a huge run up) and everything else (oil, grains, metals, etc....)
  5. Reviewing your investments in terms of yield whether it is measured in interest return (bonds, REITS) or dividends (stocks)
  6. Categorizing your investments by "tax efficiency", which favors municipal bonds (which are exempt from Federal and often state taxes) and currently dividends (taxed at a 15% rate) but punishes normal interest which is taxed as ordinary income
  7. Splitting your personal portfolio into "retirement" funds which generally are invested without paying taxes, grow (hopefully) over the years with reinvested dividends and interest, but are taxed when you retire and start taking withdrawals, from "non-retirement" funds which are subject to current taxation on dividends and interest but whose "basis" or original investment value have already been taxed. A third category is Roth investment vehicles which are taxed now but the gain or loss above the current value is not taxed when you take out funds upon retirement
These concepts are all useful ways to review how your money is being allocated across all these sectors of investing. There is no "one" right way to allocate your portfolio or to even assess how your portfolio is currently deployed. On the topic of bonds, to me they traditionally represented 1) primarily a vehicle to earn interest, with the rate of interest dependent upon the riskiness of the bond 2) a (relatively) secure means of investing meaning that you expect to get your principal back (i.e. if you invest $50,000 at 2% which unfortunately would be a great rate now you pretty much are focusing on earning $1000 / year in interest and ultimately getting back your $50,000 when the bond matures). However, the general perception that the bond world is "safe" doesn't jibe with events that have occurred over the last decade or so. These events include:
  • The massive budget deficits being run by the major world democratic powers in the US and Europe both at the Federal and regional / local levels, which are unsustainable as we found out in Greece and are likely to find out in many other places to come
  • The decline of over 30% in the US dollar against other currencies over the last few years, caused by many factors but primarily our low interest rates and a semi-deliberate policy of devaluation
  • My personal local exposure to government entities in Illinois at the state and local level (Illinois has the worst state credit rating in the US, and Cook county and the city of Chicago are famously corrupt) which leads me to expect the worst from the municipal bond market
These factors caused me to begin researching foreign bond funds. My goal was to find foreign bond funds that are
  1. From countries with a reasonable prospect of being stable and paid back (i.e. not Greece or countries with no track record)
  2. Denominated in a currency that is not US dollar based that is likely to be around in the future (i.e. Canadian or Australian dollar, the Asian currencies, etc...)
  3. Put into a fund that doesn't HEDGE vs the US dollar - many overseas bond funds hedge against the US dollar so although you get foreign investment exposure in terms of returns and risks, you still are based on the US dollars gains and losses over time. This is new because until recently most of the funds I can find tended to hedge currency exposure
  4. Have a low cost of ownership; preferably as an ETF which doesn't (generally) incur capital gains and losses on a given year; these changes are "baked" into the share price which fluctuates over time and then you can choose when and how to incur the gain or loss by selling shares rather than being forced to book the gains or losses each year depending on fund activity
I briefly considered buying individual foreign bonds but this required a lot more work and understanding than I was prepared to do. This may be something I'd consider in the future but since I don't want to be consumed in research and exposed to unknown IRS forms and risks (since we do our own taxes and direct our own investment) for now I was looking at something less complex. While it may seem that a lot of individuals are thinking the same things as me (the above thoughts are pretty obvious) sometimes you have to "wait around" for the industry to come to the same conclusions. I bought the first dividend-focused ETF (DVY) when it came out and was waiting for a while to find it (and I heard about an early cash-back credit card and was an early adopter of this, as well). PIMCO recently seemed to have what I was looking for when they released three new ETF's. The ETF's are for Australia, Canada and Germany. Here is a link to the PIMCO web site describing these three investment opportunities.
PIMCO recently introduced three country index exchange traded funds (ETFs) focused on enabling investors to capitalize on the investment opportunities in Australia, Canada and Germany. PIMCO believes these three countries have balance sheets and debt dynamics that are well positioned in the global economy, considering the potential for slower growth and ongoing deleveraging, and offer important diversification of currency exposures for U.S. investors.
This description from their web site has what I am looking for:
  • Countries whose debt load appears sustainable or well managed
  • Non US currency exposure THAT IS NOT HEDGED
  • In ETF form to limit annual capital gains and losses but allow you as the investor to choose the time for "harvesting" your gains and losses
  • A reasonable level of total expenses, which are incredibly important for interest bearing instruments at a time of low interest rates (they are 0.5% for the Australian bond fund, which is still on the high end for me)
  • A reasonable level of asset size is desired so that the ETF doesn't behave erratically or face the possibility of closure (sometimes ETF's are closed and money is given back to investors). It helps that PIMCO is huge and if they are likely to move into a sector like foreign bond ETF's they wouldn't seem likely to just shut down a fund if it grows more slowly than anticipated
  • Australia in particular offers yield (investment return) much higher than US bonds; they currently are above 4% when you'd be lucky to get 2% in US equivalent Federal debt right now. This of course is factored into the currency level vs. dollar (it is high now) so in some "grand equilibrium" scheme they may or may not be in balance; but in the short to medium term it is fair to say that Australian debt "yields" more than US equivalent debt
In my investing I generally try not to anticipate specific events but rather to have a broader and more diversified spread on investments. From a currency side, you have the Australian dollar, the Canadian dollar, and the Euro. The Australian and Canadian dollars have had a huge run-up against the US dollar, which would make someone "chasing return" salivate, and the Euro faces downward pressure for many reasons most notably the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and their expanding financial difficulties and deficits. However, the game ahead is very long, and anyone that can reliably predict the trend of currencies against the US dollar wouldn't be writing a blog like this or even commenting on it, they'd be in a giant private jet flying to their giant private island because that is an exceedingly difficult or possibly impossible thing to do. And even if the Euro goes kaput, a German focused fund would convert into the new German currency, which would be predicted to be among the best currencies of the broken-up Europe. I will look at these three funds in detail and likely buy ETF's in them which will 1) be in the bond class 2) hold a reasonable prospect of continued repayment 3) provide non US dollar diversity.

Cross posted at Trust Funds for Kids


Dan from Madison said...

One thing you don't mention (or maybe I missed it) is your time horizon. Short term sovereign bond funds are basically a currency bet whereas if you are longer out you are looking at the overall general health/non health of a country/region. I prefer the latter for a lot of reasons, and you mentioned short term volatility in the post.

Carl from Chicago said...

Good point. I am looking strictly at the long term with my investing, which is why I am considering buying the German bond fund even though I don't like the Euro in the near term.

What do you think of those ETF's?

Dan from Madison said...

I downloaded the spread sheet of the German fund holdings. A few things stick out. 47.74% of the holdings are corporate paper - that is WAY too high for my tastes in a fund like this. If I want corporate paper, I will just go buy it and save the fees - or buy the shares of the company and get the dividend. The rest of the holdings are government or "local authority" which I take it to mean some sort of kraut muni project. This is fine, but then there is "Agency Debenture" representing 8.64% of the fund. I have no idea what this is. And I am done investing in things that I don't understand or can't easily figure out. That is a large portion of the fund that I wouldn't understand, in a fund that has an already relatively low yield to (here we go again) a cigarette company that pays me cash 6% on the barrelhead (or higher) every three months and are more solid then most sovereign nations.

Carl from Chicago said...

I agree with you on the cigarette companies. Just trying to do something with my bond exposure.

I am much more likely to look at the Australian or Canadian issuances.

Thanks for taking a look at this.

Carl from Chicago said...

Also do you have German bond corporate paper in your portfolio? Do you have any tax or reporting issues with holding those securities?

Dan from Madison said...

No I don't have any corporate paper that is NOT US BASED due to the tax issues you mentioned. I would bet there are kraut corporate paper ETF's though. I would rather have one of those AND a kraut muni/govt. ETF than the combined one that you talk about above. My international exposure is basically stocks of big companies that pay (wait for it) a decent dividend and are market leaders. I pay a guy to manage this segment of my portfolio for me because I just don't have the time/energy to keep up on all of them. He is benchmarked every three months and better come through or he is fired and the next guy gets a shot.

For paper, you might look at Puerto Rico or good states like Wyoming and/or utilities operating in good states (NOT Illinois, Cali, etc.) - I have had utility and govt. paper from there for a LONG time and all it does is pay a nice coupon. If you spread out your purchases over different issues, it isn't as much of a big deal to get insurance/cd swap if the whole thing comes down.

Carl from Chicago said...

I will look for German corporate paper ETF's too that is a good point.

Once again I am just looking for some (easy) ways to get foreign bond exposure that is unhedged and meets the reasonable criteria I set (low fees, good mix of investments, etc...)

I like your approach of paying a guy and holding him to performance too.

For now for better or worse I am doing it myself and keeping it simple.

I think I am going to pick about 20 foreign stocks that are dividend payers (wait for it... the dartboard is being set up) to get foreign ETF exposure on currencies and also to let me "harvest" losses while having enough stocks to get decent diversification.

Have to reduce my US dollar exposure it is overwhelming and we are not a great long term bet.

But thanks for digging on it you make great points and if this isn't the right one something else will come along.

Dan from Madison said...

GOD that fucking dartboard. I like in general picking a nice basket of foreign stocks with dividends - this is good and should be easy with Yahoo Finance or a bunch of other sites to find ones that might be on sale too.