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New international bond fund shows promise

(MoneyWatch) Vanguard recently announced plans to launch a new International Bond Index Fund by June 30. The firm filed an amended registration statement with the SEC that replaced earlier plans to launch two bond index funds Vanguard had announced in late 2011, but never launched.

According to Vanguard, the new bond fund will track the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged). The index comprises approximately 7,000 high-quality corporate and government bonds (average credit quality AA2/AA3) from 52 countries. The index caps its exposure to any single bond issuer, including a government, at 20% to meet regulated investment company (RIC) tax diversification requirements. The top country holdings as of December 31, 2012, were Japan (23%), France (12%), Germany (11%), and the United Kingdom (9%).

The bond fund will be hedged to the US dollar, meaning that it attempts to eliminate foreign currency risk.

The expense ratios for this new fund are far lower than originally announced at 0.23 percent annually for its basic investor share class, and only 0.20 percent for the share class requiring a $10,000 minimum purchase. The ETF will have a 0.20 percent expense ratio.

Vanguard spokesperson, Linda Wolohan, confirmed the fund will have no upfront purchase fee. I asked why the funds in the previous 2011 filing were never launched and Wolohan responded "the launch was delayed to resolve some operational issues, primarily the selection and vetting of a new target benchmark for the fund. We wanted to ensure that it was reflective of the international bond market and did not pose implementation issues from portfolio management and tax perspectives."

My take

This proposed international bond offering is stronger than the originally planned two offerings announced in 2011. Lower expense ratios and the removal of the up-front purchase fees are great for investors.

The total cost of this fund, however, will be greater than the expense ratio. The fund will have hedging costs in addition to the stated expense ratios. Kenneth Volpert, Vanguard head of the taxable bond group, confirmed that Vanguard would have hedging costs to buy forward contracts in currencies and must continually buy them to stay in a hedged position. He estimated those costs between 0.05 and 0.10 percent annually. That would put the total annual costs of the fund between 0.25 and 0.30 percent.  That's still far below any other international bond fund.

Vanguard appears to have quite a bit of confidence in this new international bond fund offering as it also announced its target date retirement funds will soon include it as a part of their bond portfolios.  International bond will comprise 20 percent of the fund of fund's bond portfolios.

I've long been agnostic on international bonds and have never owned any myself. Since I'm a believer in diversification, I can't ignore the non-US bond market which, like equities, is larger than that of the US bond market. On the other hand, bonds should be your portfolio's shock absorber so I don't recommend taking on foreign currency risk. It's a big mistake to assume the US dollar will continue to decline, and believe an international bond portfolio should be hedged. However, costs to-date have been too high for me to buy even a little of this large asset class.

I'll be following the launch of this new fund and may soon be recommending it as a part of a core portfolio.