ETF Analysis - Vanguard Emerging Markets Government Bond ETF (VWOB)

TLDR

1. Even though the investment is made in dollars, it is a good investment if you want to invest in high-yielding government bonds in emerging countries.

2. The yield on the dollar is around 5.3% before taxes and maintenance fees.

3. It is not bad for the dollar fund management, but it is not recommended for short term trading. 

Summary

The Fund is a fund that follows the indices made by the pools of bonds of the emerging market countries (China, India, Turkey, etc.) as a pool of dollar bonds. Since it is a rate hike, huge capital gain cannot be expected. On the other hand, high income gain can be expected due to high interest ratio of the emerging market countries. The annual distribution of the Fund is about 4-5%.

In fact, bonds with the highest interest rates are issued in local currencies. However, hedge problems exist and mainland bond markets of the emerging markets are not fully open to foreigners. Therefore, the portfolio is made with the bonds issued with dollars. In this case, the interest rate of the local currency cannot be obtained, but the premiums from the sovereign risk of the corresponding country can be obtained. It is like Sovereign CDS (Credit Default Swaps). However, still, it is more profitable than bonds in developed countries. In addition, China and Turkey are not likely to declare a moratorium.

The price trend of the Fund is negative. However, it is not negative when we consider distribution. Since the interest rate of the dollar itself is on the rise, you cannot expect such a great rate of return, but if the interest rate is fixed at the appropriate time and you wait for the average maturity of the Fund, the interest rate will be guaranteed. (Unless one of the countries go bankrupt)

 (Source: Vanguard)

In the figure above, the red line is value converted from total profit, and the black line is the price chart of ETF considering capital gains only. Of course, there is more loss section because interest payment part is missing, but it is not actually.

The Fund has about 1042 kinds of bonds and is similar to the 1126 index items. The overall YTM (Yield To Maturity) is about 5.27%. Since 0.32% is the management fee, the expected annual rate of return is expected to be 4.95. The modified duration is 6.3 and the average maturity is about 10.2 years.

The ratios of the constituent bonds of the Fund to the respective countries are as follows. Of course, China is the most.

 (Source: Vanguard)

In most cases, the Fund invests in treasury bonds of the countries, but there are also bonds issued by state-owned enterprises. Actually, I think there is no big difference because it is national credit as well.

The benchmark index of the Fund, Bloomberg Barclays USD Emerging Markets Government RIC Capped Index is based on dollar-denominated bonds with at least one year remaining maturity. And they are treasury bonds and bonds issued by state-owned enterprises. This does not apply to the local currency denominated bonds of the countries.

In the case of such a bond fund, if you hedge against the dollar, the rate of return in KRW will be reduced by 1 to 2%. Therefore, it is better to just hold in dollars. If you hold it in dollars, when something happens in Korea, Korea risks will be hedged too. It is advantageous not to hedge at the moment. 

Domestic (Korean) brokers take about 1% to 3% of commission when they sell foreign bonds to individuals, which are not hedged, and are not pooled. It is understandable that except Brazil / Russia / Turkey, the rest of the country's returns are much lower. The local currency exchange fees are set aside, of course. As a result, if a domestic (Korean) investor invests through a securities company in Korea to invest in overseas bonds, 2 ~ 5% of commission will be taken of course. As a result, investing in overseas bonds with overseas ETFs has a good return on investment with a much smaller fee.

Risk

1. Liquidity risk

The average daily share volume is about 87,000-90,000 (around USD 75.88 per share), and the amount is about 6-7 million dollars (60-70 billion KRW). My calculations are rough, as always. Therefore, there is not much liquidity issue, and it is not difficult for the fund to develop market (market making) from the viewpoint of the fund managers. However, when creating such a market, the difference in buying / selling prices is around 5 ~ 6bp and the duration of the fund is about 6.5, so the market commission is quite high. If you invest in the fund for just one year, the basic fee 32bp (0.32%) and the indirect fee (market commission fee) 33 ~ 38bp which sums up to be almost 70bp (0.70%). Therefore, it is better to keep the money in as long as possible.

2. Credit Risk

Most of the time, the price is immediately reflected because it is directly linked to the creditworthiness of the emerging countries. You can look at the CDS trends in each country and figure out the spread risk, and you can think of the basic interest rate curve as an American bond curve. Credit risk is not small because it is linked to both interest rates and spreads.

However, there is a lot of diversification by country (except for China) and the probability of defaulting is lower than local currency bonds because it is basically a dollar-denominated bond. It also has the advantage of being able to hedge or synthesize with CDS. Of course, there will be no voluntary portfolio adjustments since it is the index-based funds. 

3. Market Risk

Market risk is the price risk of interest rate and constituent bonds under CDS. Also, the CDS may be adjusted indirectly by the exchange rate of the country, but this is the same as the question of whether the chicken is first or the egg is first. Basically, it will be mostly affected by the dollar rate and the credit default swap rate (CDS rate) of the country.

Since the duration of the fund is 6.5 and the effective average maturity is 10 years, the fund assets change quite a bit even if the interest rate changes slightly. The net asset value of the Fund will decline by 6.5% when the dollar rate changes by 1%. In the opposite case, net asset will increase, but since the interest rate will go up, I think that it will not be the case for the time being.

The fact that the real average maturity is 10 years when the duration is only 6.5 means that there are variable interest rate bonds among the holdings. Or maybe there are high-yield bonds (coupons)? Anyway, YTM 5.3% can be obtained by holding the fund for about 6.5 years.

Of course this is not an exact calculation. Because YTM itself is an IRR, we assume that the return on reinvestment is 5.3%, which is a bit unrealistic. I do not know, maybe the rate of reinvestment may be higher than 5.3 because the interest rate is high. Anyway, it's just a rational assumption. If you hold it for 6.5 years, you will not lose money for sure.

 

 

4. Political Risk

Because the Fund invests in treasury bonds, it responds sensitively to the political issues of the countries of concern. In particular, given the bond portfolio, which is exclusively for emerging economies, political volatility can be even greater. 

Conclusion

The sharpe ratio is about 0.7, and it is not bad for a bond fund of around 0.7. It seems not bad in case of dollar investment. It is higher than the domestic (Korean) interest rate and the creditworthiness of the target countries is usually higher than Korea. And if something happens internationally, it can be recovered in dollars, so you can enjoy a somewhat safe monetary position in that case.

Closing

The following is a stock / index ticker, in case you are interested.

CUSIP: 921946885

Bloomberg Index Ticker: BURCTRUU