The Best Alternative to No Interest International Bonds

By iSectors Chief Investment Officer, Chuck Self on July 11, 2019

Love delights and glorifies in giving, not receiving. – Meher Baba

 

 

 

 

 

 

 

International fixed income investors based in the U.S. must be euphorically in love since they are getting little in yield for giving their investments to fund companies. As of July 3, 2019, the portfolio yield to maturity (YTM) of the iShares International Treasury Bond ETF (IGOV) was 0.28%. That is before the 0.35% expense ratio. Since most analysts believe that the best predictor of fixed income returns is the net YTM, these investors are giving money to the managers without expecting any return!

It is even worst for short-term international bond fund holders. Many of them are concerned about rising rates so they have lowered their fixed income duration or average maturity exposure. The iShares 1-3 Year International Treasury Bond ETF (ISHG) has a portfolio YTM of -0.07! And there is a 35 basis points expense ratio charged to these investors also!

Problems with Foreign Bond Funds in the Current Environment

Why is there $1.1 billion in these two exchange traded fund (ETFs) with additional amounts in similar funds offered by State Street and others? And the economics are even worst for international fixed income mutual funds with their higher fund expense ratios and the potential for additional fees.

Most of these investors utilize international fixed income funds as currency plays. Since these bonds are denominated in the currency of the offering government or corporation, owning these bonds add foreign exchange diversification to portfolios. Historically, they receive dividends from the funds from bonds owned in addition to currency returns. With an estimated one-quarter of the global bonds in negative yield territory (all non- U.S.) currently, the foreign exchange diversification benefits are all these investors are receiving.

But these fund holders are also exposed to two other risks: rising interest rates and credit concerns. When international interest rates normalize by becoming less negative or maybe, even go positive, there will be significant capital losses in these funds. A global increase in inflation rates may be a catalyst for rising interest rates.

More understated is the credit risk in these fund portfolios. It is especially subtle for funds with “Treasury” in their names. Investors generally understand that if they own a corporate bond fund, they are exposed to the possibility of one or more of the portfolios defaulting. But an international treasury fund owns debt of sovereign governments only. On the other hand, very few countries have AAA ratings (according to Standard & Poor’s): Australia, Canada, Denmark, Germany, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, and Switzerland.

For instance, IGOV has only one-quarter of their fund in AAA-rated securities:

 

 

 

 

 

 

 

 

 

International Bond Fund Alternative

What if there was an alternative investment to international fixed income funds that:

  • Provides the diversification benefit of these funds
  • Has no credit risk
  • Incurs little duration risk
  • Lower costs to investors

Gold funds fit these requirements well. They pay no interest, positive or negative. But gold is denominated in U.S. dollars and therefore tends to rise in price when the dollar is falling and foreign currencies are rising. Also, gold has no correlation to the stock market, serving as a great a diversifier. Gold is a precious metal and not subject to credit risk. Although gold tends to perform better at lower interest rates, it does not have a direct relationship to changes in interest risk. Finally, gold ETFs have relatively low expense ratios.

This is a cyclically strong time for gold. As we recently presented in Why Gold Should Be in Every Diversification Portfolio, the last three times the yield spread between 5-year and 2-year Treasuries went negative, a recession started about a year later. During these recessions, gold was one of the few assets that gave investors flat or positive returns. As the chart below indicates, 5-year Treasuries yields fell below 2-year Treasury yields during December 2018. If a recession begins before year end 2019, the recent increase in gold prices may be the beginning of a bull market in the metal.

Investing in gold bullion funds is the most direct method to participate in this market. Features of the best funds include:

  • Backed by physical gold bars in secured vaults outside the U.S.
  • Bars allocated to the specific fund and listed on the ETF’s website.
  • Regular, random vault inspections to ensure that the bars are there
  • ETF bid/offer spreads lower than 10 basis points
  • Total expense ratios under 20 basis points

The Aberdeen Standard Physical Swiss Gold Shares ETF (SGOL), GraniteShares Gold Trust (BAR), and Perth Mint Physical Gold ETF (AAAU) fit the storage requirements. The expense ratio for the three funds are between 17 and 18 basis points. Since they all are traded on New York exchanges, they are very accessible to U.S. investors.

Can iSectors® Help an Advisor Invest in Gold?

Many advisors have taken advantaged of separately managed accounts (SMA) that provide specialized investment management for client accounts. It is even more important to find a liquid alternatives investment manager that specializes in precious metals. The iSectors Precious Metals Allocation is a unique SMA bullion fund solution for advisors’ clients.

The iSectors Precious Metals Allocation has the following advantages compared to other strategies:

  • Optimally diversified allocation of bullion funds invested in gold, silver, platinum, and palladium
  • Securities owned take advantage of the PFIC provision, if it is worthwhile for high income taxpayers
  • Invests in the most cost-efficient funds considering both expense ratio and trading fees

For more information about liquid alternatives including gold and other bullion funds, please download 5 Valuable Liquid Alternative Solutions for A Down Market from our website. The book includes a chapter discussing precious metals investments in greater detail.

If you are a financial advisor that wishes to learn more about properly diversifying allocations using precious metals, please contact Scott Jones at 800-869-5184 or [email protected].  Alternatively, you may wish to register on our website www.isectors.com to review information on the iSectors Precious Metals Allocation.

Individual investors can contact Scott Jones for a referral to a recommended iSectors advisor that can help them determine the best iSectors asset allocation for their portfolios.

By the way, Meher Baba was an Indian spiritual master who had Pete Townsend of The Who as a follower. Baby Boomers will be interested to know that Townsend dedicated the rock-opera Tommy to Baba.

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