German Bond ETF: Plenty Of Risk, Not Much Return (EWG, VGK, BUND, EWP, EWI, AUD, AUNZ)

Michael Johnston: The development of the bond ETF industry in recent years has been well documented; as investors have become more comfortable with the idea of achieving fixed income exposure through the exchange-traded structure, inflows to this corner of the market have grown significantly. Moreover, ETF issuers have gradually expanded the geographic reach of the bond ETF lineup, developing products that offer access to fixed income securities beyond U.S. borders. This innovation has allowed U.S.-based portfolios to achieve the same degree of dollar diversification in the fixed income allocation as has long been possible with equities; the bond ETF universe now consists of products targeting a wide variety of both developed and emerging markets.

With yields in the U.S. at record lows and interest rates expected to remain depressed through next year, many investors have embraced international bonds as a way to enhance total yield of their fixed income portfolios. Yields on emerging market debt, which some see as relatively low risk compared even to Treasuries, can be found in the neighborhood of 5%. Even some commodity-rich developed markets such as Australia and Canada are spitting off decent yields [for more actionable ideas, sign up for the free ETFdb newsletter].

German Bond ETF In Focus

Not all international debt, however, is capable of delivering a solid yield. German debt has performed relatively well in recent weeks, as investors have flocked towards the sovereign debt of a country widely considered to be the lowest credit risk in Europe (NYSEARCA:VGK). Germany (NYSEARCA:EWG) is one of just a few European issuers to maintain a AAA rating from S&P after last week’s downgrades, and has already felt the burden of bailing out its less fiscally responsible neighbors.

Ironically, Germany’s appeal to investors as a safe haven has made its bonds rather unattractive at present. As interest in this asset class has surged in recent weeks, the price of German bonds has been bid up–which has in turn lowered the effective yield. At a recent auction six-month German T-bills sold at a negative yield–meaning that investors were essentially paying German for the right to lend it money. Yields on longer-dated German debt is on the positive side, but not by much; 10-year bonds were recently yielding about 1.8%, or about 470 basis points more than Italian debt of the same duration.

PIMCO’s Germany Bond Index Fund (NYSEARCA:BUND), which debuted in November of last year, is the only true ETF to give exposure to the German bond market. Right now, the yield on BUND is less than compelling; the fund has an estimated yield to maturity of 1.76%, and a 30-day SEC yield of just 1.47%. The bottom line expense ratio of 0.45%–which is very reasonable given the exposure offered–will eat away at a significant chunk of any yield delivered.

Though it is hard to argue that German debt is riskier than the obligations of its cash-strapped neighbors in Italy (NYSEARCA:EWI) and Spain (NYSEARCA:EWP), it hardly seems risk-free. Germany is, after all, running a budget deficit that is expected to widen during 2012. Moreover, growth in the German economy ground to a halt in the fourth quarter of 2011, and isn’t expected to accelerate significantly in the first half of 2012. The German government is expecting the economy to expand by just 0.7% this year, which means that any bump in revenue from increased tax collections will be minimal.

Throw in the exchange rate risk associated with any euro-denominated asset, and the potential for yields on German debt to go any lower seems rather remote.

Other ETF Options

German debt stands out neither as a source of meaningful yield nor a particularly safe investment in the current environment, which makes the interest in these securities somewhat puzzling. For investors looking to generate a more attractive yield from a market that is on relatively stable fiscal footing, however, two other international bond ETFs could make for interesting options:

  • Australia Bond Index Fund (NYSEARCA:AUD): Australia was one of the first developed markets to raise interest rates following the recent recession, so it should be no surprise that AUD has a relatively attractive yield. Currently, the estimated yield to maturity on AUD is about 4.6%. Considering that Australia has an abundance of natural resources and is still rated AAA, that’s a fairly handsome return. The effective duration on this ETF is even under four years, meaning that there is not excessive interest rate risk.
  • WisdomTree Australia & New Zealand Debt Fund (NYSEARCA:AUNZ): This actively-managed ETF maintains a similar objective, though AUNZ also comes with a slice of exposure to New Zealand. With an average yield to maturity of about 4.1% and an effective duration of close to four years, AUNZ also represents a solid source of relatively safe current returns.

Written By Michael Johnston From ETF Database Disclosure: No positions at time of writing.

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