BNDX: International bond index ETF, no compelling investment thesis (NASDAQ: BNDX)
A reader asked me for my opinion on the Vanguard Total International Bond ETF (NASDAQ: BNDX). BNDX is a diversified international bond index ETF, offering broad exposure to said asset class. Although there’s nothing really wrong with the fund, it has few positives and no compelling investment thesis. BNDX’s potential returns are quite low, due to the fund’s low yield to maturity of 2.6% and the fact that bonds rarely post large and lasting capital gains. BNDX focuses on long-term bonds, so losses could increase if rates were to rise, a distinct possibility in the current inflationary environment. The risks outweigh the potential rewards, although both are relatively small. As such, I would not invest in the fund at this time.
- Investment Manager: Vanguard
- Expense ratio: 0.07%
- Yield to maturity: 2.6%
- Total returns 5-year CAGR: 2.1%
BNDX is a diversified international bond index ETF. It is administered by Vanguard, the world’s second largest investment manager and leading provider of simple, diverse and inexpensive index funds. I’m generally quite optimistic about Vanguard index funds, but BNDX focuses on a below-average asset class.
BNDX itself tracks the Bloomberg Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged). This index includes all investment grade, corporate and government bonds, issued in foreign currencies, subject to a basic set of liquidity, maturity, size, etc., criteria for inclusion. The index explicitly excludes dollar-denominated bonds, but is hedged against foreign currency fluctuations. The index also explicitly excludes non-investment grade bonds which, combined with other inclusion criteria, significantly reduce the index’s exposure to emerging market issuers. In broad terms, BNDX’s underlying index successfully tracks its intended asset class and shows no significant issues or negatives.
BNDX’s underlying index is quite broad, resulting in an incredibly well-diversified fund, with investments in thousands of securities from most relevant bond sub-asset classes and across dozens of countries. Credit quality is quite high, with an average credit rating of AA.
Diversification and quality both reduce portfolio risk and volatility and minimize losses during downturns and recessions. For example, the fund suffered minimal losses of 0.40% during the first quarter of 2020, the start of the coronavirus pandemic and the last recession. BNDX significantly outperformed stocks and high-yield corporate bonds, slightly underperformed dollar-denominated bonds, and significantly underperformed Treasuries. The fund is a reasonably safe investment, but not an effective hedge like treasury bills.
BNDX’s diverse and safe holdings are a plus for the fund and its shareholders, but pale in comparison to the fund’s minuses. Let’s look.
BNDX – Negatives
Low yield potential
BNDX’s potential returns are quite low, with the fund offering investors little income, potential capital gains, or total returns.
BNDX’s underlying holdings have a yield to maturity of 2.6%, an incredibly low figure and below average for a diversified bond fund. BNDX’s low yield is explained by the fund’s focus on high-quality, low-yielding bonds and the continued low yields of Japanese and European bonds. Interest rates are rising across the board, so yields likely increase in the coming months, but currently yields remain extremely low, a negative point for the fund and its shareholders.
Incidentally, the fund’s trailing 12-month yield currently stands at 4.0%, a bit higher than above. BNDX’s rolling yield is higher because there was a relatively large special distribution at the end of 2021, due to regulatory and accounting issues related to foreign investments. Many international funds made special distributions during the year, but these generally did not reflect the underlying generation of income or were not indicative of expected future distributions. The yield-to-maturity numbers are much more informative, at least in my opinion.
BNDX’s potential capital gains are also quite small, as the fund invests in bonds which, in the vast majority of cases, simply do not generate significant and sustainable capital gains. Bonds are essentially loans with interest rate payments, which are distributed to shareholders in the form of dividends and a predetermined price at maturity (face value). Bonds may experience temporary and usually reasonably small price changes, but the fact that prices at maturity are fixed anchors their prices and effectively prevents long-term capital gains. BNDX itself has recorded 0.6%, in fact zero, of gains since its inception some nine years ago. The results are generally in line with expectations.
BNDX offers investors a meager 2.6% yield and almost no capital gains, so total returns will almost certainly be quite low going forward, a significant negative for the fund and its shareholders.
High interest rate risk
BNDX holdings are generally older bonds, issued within the last two years. Yields are generally quite low, as the bonds were issued when interest rates were at their lowest. Maturities are usually quite long, with issuers wanting to lock in these low yields for as long as possible. As interest rates rise, investors typically sell these older, lower-yielding issues to buy newer, higher-yielding alternatives. The selling pressure is expected to result in lower prices for these older bonds and capital losses for their holders and investors, including BDNX. The fund would be able to take advantage of higher interest rates once its assets matured, ie in 9 years on average. Higher interest rates would mean immediate capital losses and higher returns in about a decade, so the net effect is hugely negative for all but longer-term investors.
Little increase in diversification
Diversification almost always reduces portfolio risk and volatility, but there are exceptions. In general terms, diversification works when returns are uncorrelated, which means that gains and losses occur in different time periods. Diversification has a particular impact when returns are negatively correlated, meaning that gains and losses occur in opposite time periods. Stocks and Treasuries are negatively correlated, especially during downturns, when stocks fall while Treasuries rise. This was the case in 1Q2020, at the start of the coronavirus pandemic.
Negatively correlated assets can be used as hedges against each other. An equity investor may decide to hedge their equity portfolio with cash investments, which should lead to reduced portfolio losses in the event of a downturn, as above.
Positively correlated assets generally cannot be used as a hedge against each other because they both suffer losses at the same time. Generally speaking, the BNDX is significantly positively correlated to dollar-denominated bonds, due to interest rate parity. Simply put, credit markets are structured so that the risk-adjusted returns of most bonds are as similar as possible, because traders arbitrate any cases where they are not. Currency hedges are also typically structured to maintain interest rate parity, although details on this are beyond the scope of this article. The performance over the past year has been very similar between these two asset classes, as expected.
While there are periods when these two asset classes diverge in their performance, they are few and far between.
In my opinion, and given the above, investing in BNDX does not significantly increase diversification from a portfolio perspective, assuming investors are exposed to US bonds. Although it is not a negative in itself, this means that the fund lacks a significant advantage. As mentioned earlier, the problem with BNDX is that it lacks a viable investment thesis, and the lack of increased diversification is part of that.
Conclusion – No Compelling Investment Thesis
BNDX is a diversified international bond index ETF, offering broad exposure to said asset class. While there’s nothing wrong with the fund, it has few positives and no compelling investment thesis. As such, I would not invest in the fund at this time.