Interest rate risk and duration
In the last part, we discussed historical returns for domestic ETFs investing primarily in U.S. corporate bonds like the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) and the Vanguard Long-Term Corporate Bond Index Fund (VCLT), as well as international bond funds investing in primarily in overseas corporate bonds like the Invesco PowerShares International Corporate Bond Portfolio (PICB) and the State Street SPDR Barclays Capital International Corporate Bond ETF (IBND). In this part, we will cover the risks inherent in these ETFs.
PICB, LQD, and IBND have durations of 5.6, 7.74, and 4.96 years, respectively, while the duration for VCLT is 13.5 years. Durations measure price sensitivities in bonds due to parallel shifts in the yield curve. The higher the bond or the bond fund’s duration, the greater is the price change for a given change in the interest rate, all else constant. So, interest rate risk is highest for VCLT and lowest for IBND amongst the funds considered in terms of duration.
For more on duration and how it affects your fixed income portfolio, read Interest rate risk: Measure and avoid the pitfalls of duration.
Standard deviation of returns and Sharpe ratio
The fund returns’ standard deviation and the Sharpe ratio provide assessments of the risks taken by the fund to earn the returns. The returns’ standard deviation over the past three years, which measure how much the historical fund returns have fluctuated around their mean, are estimated at 5.5%, 9.01%, 9.36% and 9.79% for LQD, VCLT, IBND, and PICB, respectively (source: Yahoo Finance). So, risk appears to be the lowest for LQD and the highest for PICB in terms of standard deviations.
Sharpe ratios measure whether the returns earned on the fund are commensurate with the risks taken to earn them. The Sharpe ratios for the above-mentioned funds are based on returns earned over the past three years. These are estimated at 1.16, 1.02, 0.51, and 0.44 for LQD, VCLT, PICB, and IBND, respectively (source: Yahoo Finance). So, risk-adjusted performance appears to be the best for LQD and the lowest for IBND in terms of the Sharpe ratio.
Currency risk is zero for VCLT and LQD, since both funds invest in domestic companies whose debt is U.S. dollar denominated. Both VCLT and LQD have Verizon (VZ) debt in their portfolios. PICB and IBND invest in bonds that are denominated in currencies other than the U.S. dollar, which makes them subject to currency risk. In the event the U.S. dollar appreciates, the value of the investment will decline in U.S. dollar terms, all else equal. The reverse is true if the U.S. dollar depreciates.
International funds, PICB and IBND will be subject to higher country risk compared to VCLT and LQD, since the latter two funds invest in domestic bonds, and the U.S. is generally perceived to have the lowest country risk in the world. Overseas investments command a country-risk premium to compensate them for the higher risks. IBND has ~18.4% country exposure to the U.S., compared to none for PICB, which makes IBND less risky to that extent. Top country allocation for PICB is the United Kingdom at ~18.72% of holdings.
With the Fed expected to continue the tapering of monthly asset purchases over the course of 2014 and the monetary tightening that is expected to follow, rates in the U.S. are expected to increase. Interest rates in Europe, however, are expected to hold or trend even lower due to concerns over economic growth and deflation. The European Central Bank may even start open market purchases, akin to the U.S. monthly bond buying program. All else equal, this would benefit returns on funds with significant exposure to European debt like PICB and IBND.
In the next section, we will discuss domestic and international bond funds that invest in both government and corporate debt.