New ETFs offer access to foreign bonds

Investing in bonds of individual countries requires careful observations of each nation's strengths and weaknesses, but can prove rewarding.

By TheStreet Staff Nov 14, 2011 3:39PM

By Roger Nusbaum, TheStreetTheStreet

 

Many years ago I made the obvious observation on my blog that investors needed access to foreign bonds through ETFs and that at some point these types of funds would start to be offered. Shortly thereafter came another obvious observation that the first broad-based funds would be insufficient due to huge weightings in Japan and its low yields, and I indicated that what were really needed were individual country bond funds.

 

Pimco has seemingly embraced the idea wholeheartedly by recently launching the Pimco Australia Bond Index Fund (AUD), the Pimco Canada Bond Index Fund (CAD) and the Pimco Germany Bond Index Fund (BUND). All three funds will have an expense ratio of 0.45% but it is too early for any reliable yield information other than the funds intend to pay a monthly dividend. The funds will own a mix of corporate, sovereign and quasi-sovereign -- similar to U.S. municipal bonds -- debt.

 

The strategy behind these appears to be offering bonds from relatively attractive countries fundamentally, while at the same time trading in reasonably liquid markets. Obviously, Germany is by far the healthiest economy in a very troubled region. Greece was the latest to be bailed out. Now the focus of attention has moved to Italy as rates there spiked above 7% for a short time and Italian Prime Minister Silvio Berlusconi finally stepped down over the weekend. We might see a couple of days of respite, but then there will be something else that will come along to scare either the region or the entire planet, and Germany will still be the fiscal anchor of the region.

 

The drawback to owning bund is the euro exposure. As mentioned, this is a troubled region, fundamentally, and so it stands to reason that the euro, which is of course the currency used by Germany, could face significant downward pressure. If the euro does fall then bund should also be expected to drop in price.

 

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Canada is obviously most similar to the U.S. culturally, but Canada avoided the full magnitude of the financial crisis thanks to a more conservative financial system. This is not to say that Canada is riskless. The housing market in Vancouver, and to a lesser extent Toronto, have shown signs of overheating and the amount of cross-border trade does make Canada vulnerable to a U.S. slowdown.

 

The key point of differentiation between the two countries is Canada's oil, most notably in the oil sands in Alberta. As oil has gone up in price it has made extracting oil from the oil sands more economical, in turn creating more revenue opportunity for Canada.

 

A meaningful drop in the price of oil, although unlikely, is the biggest threat to the theme.

 

The Australia bond fund will offer the highest yield as the overnight cash rate, similar to the fed funds rate in the U.S., is currently 4.5%. Australia did not have a recession in 2008 to 2009 like most of the world, when its GDP only contracted for one quarter.

 

Similar to Canada, Australia is a natural resources story and the fundamental attractiveness will remain in tact as long as demand for resources from emerging markets like China remains strong. An interruption in that demand would threaten Australia's economy.

 

The other threat to the Australian story is the housing market. Affordability rates, price appreciation and second-home ownership are all at concerning levels. While the potential magnitude of a bubble popping is likely less than in the U.S., it would negatively affect the Australia bond fund.

 

We own individual issues of sovereign debt for our clients from Canada and Australia as I believe the benefits of these countries outweigh the risks. I do not have the same conviction about Germany. Owning individual foreign bonds is very difficult for individual investors due to minimum order size. This makes the Pimco funds a very useful democratizing product.

 

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