2d illustrations and photos
~ by Snehasish Chaudhuri, MBA (Finance)
Vanguard Emerging Markets Government Bond Index ETF (NASDAQ:VWOB), as the name suggests is an exchange-traded fund (ETF) that invests in dollar denominated bonds in various emerging markets (EMs). Most of these bonds provide higher return than that of US bonds. However, these bonds are, in general, riskier than those available in U.S. markets, and the default risks are quite high in the government debts and corporate bonds of various emerging markets. If an EM bond fund is able to invest in sovereign bonds with investment grade ratings, only then can it get the benefits of both high return and low risk. VWOB, in particular, generates decent yields and total return around 5 percent, and is currently trading at a negligible premium to its net asset value (NAV).
Vanguard Emerging Markets Government Bond Index ETF
Vanguard Emerging Markets Government Bond ETF was launched and is managed by The Vanguard Group, Inc. The fund invests in dollar-denominated bonds with maturities of more than one year, that are issued by governments, government agencies, government-owned corporations, and banks. 60 percent of its assets are invested in fixed income securities with maturity between 1 and 10 years. Out of these, 30 percent bonds have a maturity between 1 and 5 years. Average effective maturity is 12.4 years. VWOB tracks the performance of the Barclays USD Emerging Markets Government RIC Capped Index by using representative sampling techniques. VWOB replicates the index by maintaining a dollar-weighted average maturity similar to that of the index. So, the fund is non-diversified by the type of securities that it invests in. However, it is well diversified geographically.
VWOB’s Investments in Many Emerging Markets Raises Concerns
Vanguard Emerging Markets Government Bond ETF has invested in 745 bonds spread over 65 countries. Unfortunately, the average credit rating is not high. 45 percent of investments are below investment grade. The fund has made significant investments (more than 3 percent of the entire fund) in high-risk markets such as Turkey, Brazil, Colombia, Peru, Dominican Republic, and Bahrain. In addition, VWOB has made some nominal investments in 23 relatively vulnerable economies which should have been avoided under any circumstances. Sovereign bonds of these countries have very high chances of default. This list includes Angola, Argentina, Belarus, Ecuador, Egypt, Ethiopia, El Salvador, Costa Rica, Gabon, Ghana, Iraq, Ivory Coast, Kenya, Lebanon, Mongolia, Mozambique, Nigeria, Pakistan, Sri Lanka, South Africa, Tunisia, Ukraine, and Zambia.
Kenya, Zambia, Egypt, Nigeria, Argentina, Ecuador, Pakistan, Sri Lanka, South Africa and Mongolia are some of the victims of the so-called Chinese debt trap, a term coined by Indian academic Brahma Chellaney to describe China’s alleged leveraging of small foreign governmental debt for its geopolitical goals. All these countries have allegedly taken loans from various Chinese banks at exceptionally high interest rates in order to invest in some financially unviable projects. Some of these countries are run by corrupt administrators and don’t raise enough resources so that they can repay their external debt. There is a practice of leasing crucial strategic infrastructure to Chinese companies in order to repay those Chinese debts. However, the fates of remaining external debts remain doubtful. Post-pandemic, some of the above-mentioned nations (Zambia, Argentina, Ecuador, Sri Lanka) have either defaulted in their sovereign debt repayment or have gone for restructuring of sovereign debt. In addition, Lebanon also defaulted on its Eurobonds amounting $1.2 billion.
Angola, Ethiopia, Egypt, Iraq, Ivory Coast, Kenya, Mozambique, Nigeria, Pakistan and Zambia are ranked among top 40 fragile economies as per ‘Fragile State Index 2022’. Terrorist insurgencies and civil wars in Iraq, Ivory Coast, Ethiopia, Ghana, Gabon, Mozambique, Tunisia, and Nigeria, have made these economies vulnerable. El Salvador’s ambitious move of making bitcoin a legal tender has backfired and led to a financial crisis. Economic activities of Belarus and Ukraine have severely been impacted by the ongoing war between Russia and Ukraine. Lebanon and Costa Rica are going through a financial crisis. Together, bonds of these 23 nations consist of 12.8 percent of VWOB’s asset under management (AUM) of $2.9 billion. $350 million investments in such bonds that can default any time doesn’t portray a very good picture about Vanguard Emerging Markets Government Bond ETF.
Almost 7.1 percent of the entire portfolio is also invested in the bonds from Turkey. Turkey is rated B by S&P and B3 by Moody’s. Turkey’s economy is in deep trouble, as the nation is witnessing a runaway inflation and a collapsing lira (Turkish currency). Inflation is estimated at triple digit, and the currency depreciated by almost 150 percent during the past one year. Though a lot of factors are responsible for such economic collapse, the Turkish Central Bank’s deliberate policy of keeping interest rates very low has led the economy spiral out of control. As a result of this, almost one-fifth holdings of the Vanguard Emerging Markets Government Bond ETF becomes extremely risky.
Brazil, Colombia, Peru, Dominican Republic, and Bahrain also have some deep rooted problems. Brazil’s economy fell into recession as extreme weather conditions, high level of unemployment, high interest rates and inflation cut short its recovery from the pandemic. Colombia has a long history of drug war and social unrest, and its economy is vulnerable to external shocks due to the structural fiscal deficit and the current account deficit. Peru, on the other hand, has been impacted by adverse global financial conditions, including high inflation and less demand from China, its main trade partner and the biggest consumer of its mineral exports.
The Dominican Republic suffers from marked income inequality; high unemployment and underemployment. On top of that, rising food costs are making it increasingly difficult for the poor to afford the basic food basket. Bahrain’s high debt levels and consistent fiscal deficit over more than a decade remain a concern. However, all these five economies are not that vulnerable and are not expected to default despite low ratings. But the fund should avoid investing in most of those 23 vulnerable and debt ridden economies in order to enhance the confidence of its investors. Investing in Turkey should better be avoided at least in the foreseeable future.
VWOB Offers Decent Yield Which May be Sustainable if There isn’t any Default
I analyze the investability of EM bond funds by evaluating the seven most critical factors for such funds – stock price performance, AUM, annual average yield, level of portfolio diversification, average credit rating, current discount to NAV and future sustainability of its yield. As I opt for funds only with yields higher than 5 percent, market price higher than $5, and AUM of more than $400 million, the Vanguard Emerging Markets Government Bond ETF falls in my investment horizon. VWOB’s stock is currently trading almost at par to its NAV of $60.7. Between 2013 and 2021, VWOB was successful in generating positive returns only in five out of these eight years. Annual average total return during this period was close to 5 percent, which is almost equal to VWOB’s yield.
The Vanguard Emerging Markets Government Bond Index ETF was formed in May 2013 and has been paying continuous monthly dividends since then. Annual average yield has mostly ranged between 4 and 5 percent. Average yield recorded since 2014 has been 4.5 percent, and trailing twelve months’ (TTM) yield has been 5.25 percent. As the $2.9 billion bond portfolio earns an average coupon of 4.9 percent and has a very low expense ratio of 0.2 percent, we can be pretty confident about generating a steady yield around that region. However, its plans may get jeopardized in case of any default. A low average credit rating raises the overall risk of its portfolio. As a significant portion of VWOB’s portfolio is invested in high-risk and low-rated bonds, I am not fully confident about the sustainability of its current yield.
Investment Thesis
I don’t find the Vanguard Emerging Markets Government Bond Index ETF to be lucrative according to my “7 Factor Model for Evaluating Emerging Market Funds.” It qualifies for the minimum requirements with respect to AUM, stock price, and has a decent historical yield between 4 and 5 percent. Historically, total returns have been somewhat equal to its annual average yield. However, the portfolio is not well diversified and carries some unwanted risks. I don’t think that VWOB has invested in the right markets. Though negligible, the fund at present is trading at a premium to its NAV. I expect this fund to sustain its current level of yield, only if there is no default. Default risk is something that doesn’t instill high levels of confidence. In my opinion, the fund should avoid investing in those 20 high-risk small-sized economies in order to enhance the confidence of its investors. For the time being, I am not bullish about this fund.
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