Best Bond Funds | Scarce low cost international bond index mutual funds



Scarce low cost international bond index mutual funds

Scarce/non-existent low-cost international bond index mutual funds

Given the complexities of investing in bonds across many countries and currencies, somewhat higher costs should be expected. However, when one considers all the available low-cost, US bond investment funds (mutual funds and ETFs), there are currently no truly low-cost international bond mutual funds. All reasonably low cost US domiciled international bond funds are ETFs, and none are mutual funds.

This creates an investment implementation dilemma. While global bond fund diversification would be desirable, is it worth owning them, considering the added costs if you are going to utilize mutual funds exclusively and do not wish to be involved with the added complexities of ETFs? In an ideal world for the individual investor, both US domestic and international bond index mutual funds with very low costs would have available, but that is not the current situation.

Cost efficient international bond investing – an index mutual fund dilemma

At this point, there are few even “lower” cost funds international cash or bond mutual funds with acceptable costs. Regarding international bond funds, only two retail international bond mutual funds were found with annual management expense ratios under 1%, and those expense ratios were above .8% per year. Furthermore, these funds have relatively high turnover, which can be an indicator of additional hidden costs related to trading and to short-term returns and non-qualified dividends that would be taxed at ordinary income tax rates.

Other bond mutual funds in the world bond category with have other shortcomings, including:

  • unabashed active management with excessively high turnover inappropriate to the duration of the underlying bonds,
  • inadequate diversification,
  • insufficient total net assets,
  • very high investment minimums, and/or
  • strategies that involve debt leverage, which amplifies risk.

When the emerging markets bond mutual fund sub-category is considered, expense ratios are even higher, while these other shortcomings persist.

The long-term historical risk premium paid to bondholders of US dollar denominated intermediate-term bonds has been roughly 2.75% in real dollar terms – after 3% inflation has been removed from the analysis. (Since 1926, the compounded annual US dollar domestic inflation rate has been very close to 3% per year.) Thus, even these two international bond mutual funds would consume almost a third of the total historical US bond market real dollar returns – without even considering turnover-trading costs and taxes.

Of course, one might hope that international bond funds would have higher returns than US dollar denominated bond funds, but we always need to keep in mind that risk adjusted returns are what one needs to pay attention – not just relative rates of return. International bond funds would add exposure to exchange rate fluctuations and other additional investment risks. Thus, one would need to evaluate whether there could be a reasonable expectation of significantly higher bond yields to compensate for these substantial costs, the exchange rate risk, and any other risks.

While in general, there are numerous world and emerging markets bond mutual funds, when screened with reasonable selection criteria, none are left to suggest. These international bond mutual funds have far higher fees than domestic bond funds of comparable duration.

Very good news about low cost international bond mutual funds and ETFs

Just as this book was being finalized near the end of 2011, the Vanguard Group filed investment fund registration statements with the Securities and Exchange Commission and announced that it would enter the international bond mutual fund and ETF market. In early 2012, Vanguard will introduce two broadly diversified international bond funds, which are to be named: the Vanguard Total International Bond Index Fund and the Vanguard Emerging Markets Government Bond Index Fund.

Vanguard’s new international bond funds will put significant downward pressure on the US domiciled international bond investment fund market. Vanguard’s announced expense ratios will undercut the competition, particularly with international bond mutual funds. Currently, world bond fund expense ratios average over 1.1% per year, and emerging markets bond fund expense ratios average over 1.3% per year. In addition, it is reasonable to expect that in the coming years Vanguard will expand its offering of international bond funds. Let the price competition begin.

These are the announced expense ratios and investment minimums:

Vanguard Total International Bond Index Fund

  • Investor shares (0.40% expense ratio; $3,000 minimum)
  • Admiral shares (0.30% expense ratio; $10,000 minimum)
  • ETF shares (0.30% expense ratio; no minimum, but brokerage costs)
  • Institutional shares (0.25% expense ratio; $5M minimum)

Vanguard Emerging Markets Government Bond Index Fund

  • Investor shares (0.50% expense ratio; $3,000 minimum)
  • Admiral shares (0.35% expense ratio; $10,000 minimum)
  • ETF shares (0.35% expense ratio; no minimum, but brokerage costs)
  • Institutional shares (0.30% expense ratio; $5M minimum)

Note that each of these funds will carry a purchase charge, which is not a sales load. The purchase charge for the Total International Bond Fund will be 0.25%, and the purchase charge for the Emerging Markets Government Bond Fund will be 0.75%. Before, Vanguard has instituted purchase charges with some of their international equity funds. A purchase charge is paid into the fund itself. These kinds of purchase charges help to fund the acquisition cost of securities, and they tend to discourage the entry of short-term investors. Since the fees are paid into general fund assets that are owned by shareholders and since long-term investors would amortize these purchase fees over many years, such purchase fees tend to be relatively inconsequential, if not beneficial, to long-term investors.

You could gain international bond exposure economically through ETFs

If you want to include lower cost global and international bond index funds in your portfolio, you could consider bond ETFs. A limited number of international bond ETFs have significantly lower costs compared to international bond mutual funds. However, you would need to keep your trading costs in mind, if you choose international bond ETFs. Furthermore, do not ignore potentially substantial bid-ask spreads and discounts and premiums relative to net asset value.

If you understand how to trade ETFs and can manage a long-term buy-and-hold investment strategy using ETFs in a discount brokerage account, then you have a few low cost international bond ETF choices. Currently, several world bond ETFs with management expenses in the .35% to .50% per year range can be purchased. These funds are reasonably broadly diversified. Moreover, they have portfolio turnover appropriate to the duration of the underlying investments. When compared to similar US dollar denominated bond ETF funds, they have somewhat higher costs but not excessively higher costs.

What to do about international bonds, when using only bond index mutual funds and not ETFs

Using only mutual funds, you might need to get a bit more creative with your investment portfolio.

First, once you understand the concepts involved with investment tax location (See: “Asset allocation, tax location, and emergency cash management”), you will realize that there are tax optimization reasons to hold your allocation to bonds within your retirement accounts. You might get lucky when you look at the international bond mutual fund choices available within your employer sponsored 401k, 403b, 457, or other retirement plan. You might find that a not-so-expensive international bond institutional fund has been made available to you and that could do the trick.

Another alternative would be to make some modest adjustments to your US versus international equity mutual fund proportions. Without economical, international mutual funds for your cash and bond allocations, all of your cash and bond investments would be US dollar denominated. If you were hesitating to hold at least 50% of your equity allocation in non-US stock mutual funds, as would be suggested by the fact that well over half the world’s total stock capitalization value is now in countries outside the US, then this might provide even more support for increasing your international stock allocation.

If you cannot get economical international exposure via bond mutual funds, you certainly can do so with low cost international stock mutual funds. Broadly diversified international equity mutual funds can be purchased at a much more reasonable cost than international bond mutual funds. While this is a different kind of investment exposure, a modest allocation shift could substitute until sometime in the future – when low-cost international bond index mutual funds become more widely available for reliable low-cost mutual fund vendors.

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