William_Potter
The Vanguard Emerging Markets Government Bond ETF (NASDAQ:VWOB) provides a low-cost way for investors to gain exposure to emerging market sovereign bonds.
Historically, EM bonds were touted as a way to diversify one’s portfolio as well as pick up a higher yield. However, with the recent rise in U.S. interest rates, the relative attractiveness of EM bonds have decreased. Furthermore, EM bonds have a high historical correlation with U.S. domestic high-yield bonds. If/when the U.S. markets catches a cold, emerging markets will likely catch pneumonia and may not provide the diversification benefits investors are hoping for.
Fund Overview
The Vanguard Emerging Markets Government Bond ETF provides low-cost exposure to bonds issued by emerging market governments. The VWOB passively tracks the Bloomberg USD Emerging Markets Government RIC Capped Index (“Index”), an index designed to measure the returns of U.S. dollar-denominated bonds of emerging market governments and government-related issuers. Individual issuers are capped at 20% of the index and the aggregate exposure to issuers greater than 5% is capped at 48% of the index.
The VWOB ETF has $3.4 billion in assets and charges a 0.20% expense ratio.
Emerging Markets As A Diversifier
On a portfolio basis, emerging market bonds can act as a diversifier, as emerging markets may be less correlated to U.S. markets than similar yielding domestic bonds. Also, due to the perceived risk of emerging markets, emerging market bonds may carry higher yields.
On the other hand, some emerging markets like Argentina have been serial defaulters on their debt obligations, so emerging market bonds do carry real sovereign default risk.
Portfolio Holdings
Figure 1 shows VWOB’s portfolio composition. The VWOB ETF has an aveage duration of 7.3 years and average coupon of 5.0%.
Figure 1 – VWOB portfolio characteristics (vanguard.com)
Figure 2 shows the top 20 issuers in the VWOB ETF. Saudi Arabia is the largest issuer, at 9.5% of the fund, followed by Mexico at 9.5%, Indonesia at 7.4%, Turkey at 7.2%, and the UAE at 6.5%. Altogether, the top 10 issuers account for 60.2% of the fund and the top 20 account for 82.1%.
Figure 2 – Top 20 issuers of VWOB ETF (vanguard.com)
55% of the fund’s holdings are rated investment grade (“IG”) or better by the rating agencies (Figure 3).
Figure 3 – VWOB credit quality allocation (vanguard.com)
Returns
Overall, the emerging market bond asset class has delivered poor historical returns, with 3 and 5 Year average annual returns of -4.2% and -0.1% respectively to January 31, 2023 (Figure 4).
Figure 4 – VWOB historical returns (morningstar.com)
2022 was an especially bad year for VWOB, as the rise in global interest rates severely punished the ETF with a -16.7% drawdown (Figure 5).
Figure 5 – VWOB annual returns (morningstar.com)
Distribution & Yield
The VWOB ETF pays a modest monthly distribution, with a trailing 12 month distribution rate of $3.25 / share or 5.3% yield. VWOB’s distribution has been fairly consistent since inception (Figure 6), and would have screened attractive during the ultra-low interest rate years from 2015 to 2021, when the iShares 7-10 Year Treasury Bond ETF (IEF) yielded ~2% (Figure 7).
Figure 6 – VWOB historical yields (Seeking Alpha) Figure 7 – IEF historical yields (Seeking Alpha)
However, with the recent rise in interest rates, 10-Yr U.S. government treasuries are now yielding north of 3.5%, so emerging bond yields are relatively less attractive.
VWOB Is JNK In Disguise?
Another factor VWOB investors should consider is that although emerging market bonds are billed as a portfolio diversifier, they do have fairly high correlations to U.S. junk bond yields. In fact, when looking at historical monthly correlations of returns between VWOB, IEF, and the SPDR Bloomberg High Yield Bond ETF (JNK) for the period July 2013 (inception of VWOB) to January 2023, we can see that VWOB is highly correlated to JNK, with a 0.82 correlation (Figure 8).
Figure 8 – VWOB vs. IEF and JNK correlation (Author created with Portfolio Visualizer)
In layman terms, what this means is that when the U.S. economy catches a cold, emerging markets usually follow suit and falls sick.
Considering the high correlation between VWOB and JNK, it is doubtful the emerging market bonds asset class provides as much diversification as pundits claim. Coupled with the fact that since inception, the VWOB has provided lower CAGR returns (2.6% vs. 3.2% for JNK) and higher volatility (9.1% vs. 8.2% for JNK), I would recommend investors stick with domestic high yield bonds if they want diversification in their bond portfolios (Figure 9).
Figure 9 – VWOB vs. IEF and JNK (Author created with Portfolio Visualizer)
Conclusion
The VWOB ETF provides a low-cost way for investors to gain exposure to emerging market sovereign bonds. Historically, EM bonds were touted as a way to gain diversification benefits as well as a higher yield against U.S. treasuries.
However, with the recent rise in U.S. interest rates, the relative attractiveness of EM bonds have decreased. Furthermore, EM bonds have a high historical correlation with U.S. domestic high-yield bonds. If/when the U.S. markets catches a cold, emerging markets will likely catch pneumonia and may not provide the diversification benefits investors are hoping for.
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