Friday, 9 December 2011

High Income Foreign Bond ETFs

With interest rates being so low these days, many investors are casting their eyes further afield in the search for better returns. The benchmark Canadian bond ETF iShares DEX Universe Bond Index Fund (TSX symbol: XBB) offers a paltry 2.3% yield to maturity. Even its current cash distribution yield is only 3.5% (per the TMX Money XBB quote). Let's therefore have a look at some foreign bond ETFs available from Canadian fund providers Claymore, BMO Financial and BlackRock / iShares (new entrant Vanguard doesn't seem to offer any) to see the pros and cons of what they offer.

The ETFs fall into two groups: US corporate bonds and government bonds from Emerging Market countries. Interestingly, no fund seems to offer developed country bonds (so there aren't any opportunities to take a flier on Greek or Italian debt!).

Emerging Markets
US Corporate
Currency hedging is a worthwhile common feature - All of the funds use futures contracts to hedge the swings of the Canadian dollar against the US dollar. Since currency swings can easily overwhelm the basic bond returns from interest and capital appreciation, we consider currency hedging to be a desirable feature in general. However, the hedging operation is not free or perfect and that usually causes a reduction in the net return and under-performance compared to each ETF's index. Not all the ETF managers do an equally successful job. In our comparison table below, we see that ZHY has done worst with a -1.3% performance drag against its index. In contrast, the best result over the past year has come from XIG which has achieved the unusual result of a performance boost over the index of 0.9%! Most probably XIG's boost comes from unintended profits from the futures hedging contracts, as suggested by the fact that XIG is one of the iShares ETFs with capital gains to distribute in 2011. For more on how tracking error comes about, see Rob Carrick's MoneyShow article Watch Out for Tracking Error When Buying ETFs.

There are a number of US-traded bond ETFs (see list here), both for US bonds and international bonds, but none are Canadian dollar-hedged. A Canadian investor would face both bond and currency risk. In our view currency exposure is best achieved, and sufficiently so, through foreign equity holdings. That's a big reason why we've left them out of this review.

XIG comes out best on MER - Its 0.3% MER is about half that of the other ETFs.

Return vs default risk profile is the key differentiator - Whether we compare by cash distribution yield or more properly by the yield to maturity figures, we first note that all the ETFs offer superior returns varying from 1% to 6% over XBB. However, there's a catch - risk. There is a marked difference amongst the ETFs with respect to default risk, as measured by credit ratings from Standard & Poors (see Wikipedia's table that explains the ratings). Our comparison table shows with a big red line the key cut-off between ratings of investment grade and those riskier ratings underneath. XIG is clearly the safest and it correspondingly has the lowest returns to offer. ZEF and XEB on the S&P ratings measure rank next safest but the high concentration of assets in the top ten countries (such as Mexico, Russia, Korea, Brazil, Venezuela and the Philippines) makes us raise that risk estimate somewhat. ZHY, XHY and CHB are all quite diversified in the sense of having many holdings and low concentration but if a recession hits, it is likely many of these weaker companies will hit the skids at the same time. Peaks of default also happen with governments as we are seeing in the European contagion scenario and as we discussed a few months back in this post on Default Risk. All this is reflected in the year to date evolution of market price of the various ETFs , shown in the Google Finance chart below. XIG is up nicely, XEB and ZEF up a bit and the other three are down. XIG has also been more stable through the year.

Bottom line
XIG works best for investors who want stability with steady cash income.

The others work best when an investor wants cash income, is able to accept higher risk and wants to have another asset type that will help diversify the portfolio since the ETFs will not move in tandem with other equity or Canadian bond holdings.

All but one of these ETFs are best held in registered retirement accounts rather than a taxable account (since the cash distributions are foreign income). The exception is CHB which can be held in taxable account since it doles out Return of Capital and Capital Gains through its clever (and legitimate) use of forward agreements.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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