Nation-Building in Your Bond Portfolio

Your Bond Portfolio
Photographer by Jerome Favre/Bloomberg

February 27 (Bloomberg) -- Maybe it wasn’t enough for speculators to gamble on whether the Italian bond market would escape economic Armageddon. They needed to leverage their bets, too. How else to explain the March 2011 introduction of the PowerShares DB 3x Italian Treasury Bond Futures exchange-traded note? It promises to triple the monthly return of the bonds for a nation some analysts think is teetering on the brink of collapse. So far, so good: The fund is up 41.5 percent, year-to-date, more than any other bond fund--and most equity ones, too.

The PowerShares product is one of 15 new, single-country, foreign-bond exchange-traded products launched in the past 12 months. “The two big trends in ETFs and ETNs over the last couple of years have been targeted foreign exposure--to get access to single countries--and the move toward fixed income,” says Martin Kremenstein, chief investment officer of Deutsche Bank’s db-X Group, which issued and manages the ETNs for PowerShares. “We’re marrying those two trends.” PowerShares offers eight different foreign-bond ETNs for Germany, Japan and Italy, half of which are leveraged. Its Japan ETN allows investors to make a leveraged bet against Japanese bonds, tripling the inverse of their returns.

Tactical Precision

Not every ETF is so high-risk. In November of last year, Pimco introduced three unlevered ETFs tracking German, Australian and Canadian government bond indexes. Economically, these countries may seem to be models of stability, compared to the U.S. “Many domestic investors have heightened concerns about swelling U.S. debt levels, slow economic growth and a weakening dollar and are seeking opportunities to diversify outside the U.S.,” says David Fisher, who manages the new index ETFs. “With the U.S. economy now representing a much smaller share of global gross domestic product, it currently makes sense to invest in countries with relatively healthy economic fundamentals and robust growth trajectories, such as Australia, Canada and Germany.”

Financial advisers who want to allocate bond portfolios among nations with more tactical precision have stoked demand for these ETFs. “When you take a really broad-based approach to an international bond ETF, you’re overweighting those countries that have most mismanaged their finances,” says Tyler Mordy, research director of HAHN Investment Stewards & Co., a Toronto-based financial advisory firm that specializes in ETFs.

That’s because most bond indexes are market-capitalization weighted, which means the countries that have issued the most debt--and are thus the most over-leveraged--have the largest weightings in ETFs that track those indexes. “So we favor single-country bond ETFs or, at the least, regionally focused ones like an Asian local-sovereign-debt bond ETF,” Mordy says.

China Bets

Of the new country ETFs, Mordy is most interested in the Chinese bond funds, such as the Market Vectors Renminbi Bond ETF. He thinks the Renminbi currency is undervalued and that the ETF’s yield to maturity of about 3 percent, on top of the potential for currency appreciation, will lead to good returns. “China doesn’t have Western-style capitalism, where currencies are free-floating,” he says. “The government is managing its Renminbi appreciation with an explicit target of five to seven percent a year. So we think the case for investing in that currency is really strong.”

Still, given the credit and interest-rate risks of investing in a volatile emerging market, Mordy wouldn’t allocate more than five percent of the portfolios he manages to this fund.

Different Animals

There are some important structural differences between foreign-bond ETFs and foreign-bond ETNs. ETNs are actually bonds; in PowerShares's case, they are issued by Deutsche Bank. So if Deutsche Bank were to go bankrupt, you could lose your investment.

The new foreign ETNs, though bonds themselves, don’t actually invest in bonds. They track bond futures in their chosen countries. As a result, they don’t pay out any interest; the interest gets added to the value of the ETN’s share price. This has significant advantages because shareholders won’t owe any taxes on a bond ETN until they sell it. If they hold it for over a year, they get taxed at the long-term capital gains rate of 15 percent.

Investors should keep a close eye on the tax treatment of ETNs, which can get tricky. For tax purposes, ETNs are treated as prepaid contracts. In 2007, the IRS ruled against embedded income gains on currency ETNs being treated exclusively as capital gains while investors in competing currency ETFs had to pay income taxes. The same dynamic could play out with bond ETNs and ETFs.

By contrast, some bond ETFs, such as Pimco’s, invest in actual bonds and pay interest, which is taxed as income at a maximum rate of 35 percent. On the positive side, there is no credit risk to the ETF structure.

In the case of that leveraged Italian-bond ETN, it will likely be the best bond investment of 2012--or the worst. “A default of Italian debt, which is the fourth-largest bond market in the world, would set the stage for the financial Armageddon we saw in 2008,” says Gibson Smith, co-manager of the Janus Global Bond Fund. “I don’t think the politicians, the financial regulators and the leaders of the global economy are going to allow that to happen.”

Currently, 10-year Italian government bonds yield about 5.4 percent, down from a November 2011 peak of 7.4 percent. (Bond prices move inversely to their yields.) U.S. 10-year Treasury bonds yield 2.o percent. That's a big gap, but “leverage cuts both ways on the upside and the downside,” notes Mordy. “We don’t employ leverage for our clients.” For investors, rather than speculators, an urge for something Italian may be best satisfied with a nice Brunello.