The Risk of International Bond Investing

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bck63
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The Risk of International Bond Investing

Post by bck63 » Sat Aug 10, 2019 12:02 pm

I have been doing a lot of reading and research in order to determine how much I should diversify my bond holdings internationally.

One thing has immediately jumped out at me. When I look at the credit ratings of the holdings in Vanguard Total World Bond ETF (which includes US Bonds), bonds rated Baa by Moody's comprise 50.9% of the ETF.

Bonds in Vanguard Total Bond Market ETF that are rated Baa comprise 17.5% of the ETF.

Per Moody's, Baa-rated bonds "are subject to moderate credit risk. They are considered medium grade and may possess speculative characteristics." My initial reaction is that this in and of itself is enough to keep me away from adding more international bonds to my portfolio (I do own some in a target date fund. My total international bond allocation represent about 5% of my portfolio.

Just wondering if I'm on the right or wrong track in this regard.

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Re: The Risk of International Bond Investing

Post by nisiprius » Sat Aug 10, 2019 12:18 pm

Dunno. Morningstar is showing

Vanguard Total Bond Market Index, VBTLX with an average credit rating of "AA."
Vanguard Total Intl Bd Idx Admiral™ VTABX with an average credit rating of "A."
Vanguard Total World Bond ETF BNDW with an average credit rating of "A."
Vanguard Emerging Mkts Govt Bd Idx Inv VGOVX with an average credit rating of "B."

So, that confirms (as expected) that the credit quality of the international bond funds is lower, but, at A, it still would seem to be "investment grade."

As is so often the case, yeah, international is riskier, just as Vanguard says for VTABX: "Because it invests in non-U.S. bonds, the fund is also subject to additional risks." I notice that for BNDW they say in so many words "Provides current income with high credit quality."
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Re: The Risk of International Bond Investing

Post by Valuethinker » Sat Aug 10, 2019 12:30 pm

bck63 wrote:
Sat Aug 10, 2019 12:02 pm
I have been doing a lot of reading and research in order to determine how much I should diversify my bond holdings internationally.

One thing has immediately jumped out at me. When I look at the credit ratings of the holdings in Vanguard Total World Bond ETF (which includes US Bonds), bonds rated Baa by Moody's comprise 50.9% of the ETF.

Bonds in Vanguard Total Bond Market ETF that are rated Baa comprise 17.5% of the ETF.

Per Moody's, Baa-rated bonds "are subject to moderate credit risk. They are considered medium grade and may possess speculative characteristics." My initial reaction is that this in and of itself is enough to keep me away from adding more international bonds to my portfolio (I do own some in a target date fund. My total international bond allocation represent about 5% of my portfolio.

Just wondering if I'm on the right or wrong track in this regard.
So risk number 1 is currency risk. But the fund hedged that away and the residual risk should be very small.

Risk number 2 is credit risk or "do you feel lucky today?" -- Clint Eastwood in Dirty Harry.

Italian government bonds yield say 3 per cent more than German which yield minus 1 per cent. The process of currency hedging will increase your approximate yield on German govt bonds to US Treasury yield ie c 2 per cent assuming equivalent credit risk.

So the Italian govt bonds hedged into USD yield say 5 per cent (3 per cent more than the credit risk free bonds of the eurozone hedged into dollars).

But you have a non zero risk that Italy defaults. You don't need Moodys to tell you that the difference in bond yields tells you that there is a roughly 3 per cent pa greater chance of Italy defaulting than Germany (very roughly).

And here's the clincher. If Italy goes anywhere near an actual risk of default global financial markets will plunge. Default risk and equity risk are correlated. That is even more true re corporate bonds.

The argument for international bonds are that yield curves are of different shapes so even currency hedged you are diversifying across interest rate moves. There is diversification bonus there but it is fairly small.

Vanguard wrote a paper about international bonds and concluded they were worth having on diversification grounds.

But you are diversifying into higher credit risk. Not all countries have govt debt instruments that are as safe as US Treasury bonds are presumed to be.

Btw particularly for countries Moody's S&P etc tend to be lagging indicators not leading. The bond market "spreads" ie the yield gap in the bonds over the safe bond in the same currency moves out before the rating changes not the other way. Yet another example of market efficiency at work.

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Re: The Risk of International Bond Investing

Post by columbia » Sat Aug 10, 2019 12:32 pm

Do I think that a number of the countries represented in BNDX could default? Yes, that’s certainly conceivable.

https://investor.vanguard.com/etf/profi ... folio/bndx


I do not think that about US treasuries, so I would expect to receive a greater total return from BNDX, if I were to invest in it.

Is the additional risk worth it? Who knows and I won’t be finding out. 😀

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Re: The Risk of International Bond Investing

Post by grabiner » Sat Aug 10, 2019 3:25 pm

bck63 wrote:
Sat Aug 10, 2019 12:02 pm
One thing has immediately jumped out at me. When I look at the credit ratings of the holdings in Vanguard Total World Bond ETF (which includes US Bonds), bonds rated Baa by Moody's comprise 50.9% of the ETF.
This number is wrong. Total World Bond ETF holds Total International Bond ETF (26.2% rated Baa) and Total Bond Market ETF (17.5% rated Baa), so it should have an overall 22% of its bonds rated Baa.
nisiprius wrote:
Sat Aug 10, 2019 12:18 pm
Dunno. Morningstar is showing

Vanguard Total Bond Market Index, VBTLX with an average credit rating of "AA."
Vanguard Total Intl Bd Idx Admiral™ VTABX with an average credit rating of "A."
Vanguard Total World Bond ETF BNDW with an average credit rating of "A."
Vanguard Emerging Mkts Govt Bd Idx Inv VGOVX with an average credit rating of "B."
And this implies that Morningstar is doing the computations correctly. Bond grades do not average the way grades average in school, because the default risk difference between BBB and BB is more than the difference between AAA and BBB. Morningstar averages the estimated default risk of all the bonds in the fund, and then converts it back to a grade, so that a fund which was 75% AAA (near-zero risk) and 25% BB (20% ten-year default risk) would rate BBB (5% ten-year default risk). A fund which was 50.2% rated BBB could not have an overall rating of A even if the other have of its bonds were risk-free.
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Re: The Risk of International Bond Investing

Post by Northern Flicker » Sat Aug 10, 2019 4:00 pm

bck63 wrote:
Sat Aug 10, 2019 12:02 pm
I have been doing a lot of reading and research in order to determine how much I should diversify my bond holdings internationally.

One thing has immediately jumped out at me. When I look at the credit ratings of the holdings in Vanguard Total World Bond ETF (which includes US Bonds), bonds rated Baa by Moody's comprise 50.9% of the ETF.

Bonds in Vanguard Total Bond Market ETF that are rated Baa comprise 17.5% of the ETF.

Per Moody's, Baa-rated bonds "are subject to moderate credit risk. They are considered medium grade and may possess speculative characteristics." My initial reaction is that this in and of itself is enough to keep me away from adding more international bonds to my portfolio (I do own some in a target date fund. My total international bond allocation represent about 5% of my portfolio.

Just wondering if I'm on the right or wrong track in this regard.
Yes, you probably don’t want to hold a world market cap allocation to bonds. TIPS are also a good diversifier for nominal bonds. Including equal amounts of int’l bonds and TIPS as a diversification will not lower credit quality, say:

54% BND
23% BNDX
23% VTIP

which is the approximate bond allocation breakdown of Vanguard Target Retirement Income as an example.
Last edited by Northern Flicker on Sat Aug 10, 2019 4:34 pm, edited 1 time in total.

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Re: The Risk of International Bond Investing

Post by nisiprius » Sat Aug 10, 2019 4:01 pm

grabiner wrote:
Sat Aug 10, 2019 3:25 pm
...This number is wrong. Total World Bond ETF holds Total International Bond ETF (26.2% rated Baa) and Total Bond Market ETF (17.5% rated Baa), so it should have an overall 22% of its bonds rated Baa...
:!: :!: :!: :!: :!:

Wow. Vanguard's own website appears to have the numbers totally wrong on this. Maybe I am starting to get worried about Vanguard's IT operation.

All screenshots are from the BNDW, BND, and BNDX portfolio tabs.

BNDW
Image
Image

BND
Image

BNDX
Image

A few minutes with a spreadsheet shows me that the composition by bond rating of BNDW should be:

Image

31.07% U. S. Government
12.55% Aaa
13.38% Aa
18.97% A
22.03% Baa

Indeed, the statement that BNDW contains "-0.2% US Government" is...

...I don't know what to say. I can't even figure out any plausible way they could have made that mistake.

I wonder where to report the error.
Last edited by nisiprius on Sat Aug 10, 2019 4:34 pm, edited 1 time in total.
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Re: The Risk of International Bond Investing

Post by staustin » Sat Aug 10, 2019 4:09 pm

As was discussed several times this past week, the eurozone in particular is battling deflation. https://tradingeconomics.com/euro-area/money-supply-m3, As the chart indicates, the european central bank has massively expanded the money supply via q/e since 2015. Negative yields and politically instability in varying degrees these days. Thus, at least in my own portfolio allocation, the wife and i have elected not to invest any of our hard earned dollars in these type instruments or funds weighted heavily in european stocks. There are better alternatives to consider; emerging markets, and, regardless of short term friction, asian markets are worthy of a look. There are always risks, but, at least for us, we've decided to hedge our bets by allocating some of our dollars elsewhere. China, in particular.
Last edited by staustin on Sat Aug 10, 2019 4:33 pm, edited 1 time in total.

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Re: The Risk of International Bond Investing

Post by nisiprius » Sat Aug 10, 2019 4:29 pm

P. S. Morningstar's numbers, BNDW, "Portfolio" tab are in decent agreement with my calculation, but since Morningstar and Vanguard are both presenting data for June 30th, 2019 I don't know why it isn't even closer... Morningstar appears to have counted US Government as "AAA," which is reasonable because three of the four ratings agencies (NRSROs) do rate the US Government as AAA.

Image
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Re: The Risk of International Bond Investing

Post by willthrill81 » Sat Aug 10, 2019 4:36 pm

Hmm...Extra credit risk with VTABX vs. VBTLX for only an 8 basis point higher SEC yield + uncompensated currency risk = A big 'uh uh' from me.

The huge Vanguard mistake here is very concerning.
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Re: The Risk of International Bond Investing

Post by grabiner » Sun Aug 11, 2019 8:20 am

willthrill81 wrote:
Sat Aug 10, 2019 4:36 pm
Hmm...Extra credit risk with VTABX vs. VBTLX for only an 8 basis point higher SEC yield + uncompensated currency risk = A big 'uh uh' from me.
Vanguard hedges away the currency risk; this is why the two funds have similar volatility.
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Re: The Risk of International Bond Investing

Post by willthrill81 » Sun Aug 11, 2019 9:31 am

grabiner wrote:
Sun Aug 11, 2019 8:20 am
willthrill81 wrote:
Sat Aug 10, 2019 4:36 pm
Hmm...Extra credit risk with VTABX vs. VBTLX for only an 8 basis point higher SEC yield + uncompensated currency risk = A big 'uh uh' from me.
Vanguard hedges away the currency risk; this is why the two funds have similar volatility.
I wasn't aware that it was a hedged bond fund. Thanks.
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Re: The Risk of International Bond Investing

Post by nisiprius » Sun Aug 11, 2019 8:39 pm

By comparison, the breakdown of VGOVX, the Vanguard Emerging Markets Bond Index Fund, really is quite low in credit quality. Morningstar's page an average credit rating of "B" (below investment grade), and, interestingly enough, lower than the category average of "BB."

From Vanguard's web page, "Portfolio" tab:

U.S. Government -0.1%
Aa 7.4%
A 19.2
Baa 30.2
< Baa 43.3

This time, Morningstar's numbers are almost identical to Vanguards. I wonder what's with that -0.1%?
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Re: The Risk of International Bond Investing

Post by fennewaldaj » Mon Aug 12, 2019 7:56 pm

nisiprius wrote:
Sun Aug 11, 2019 8:39 pm
By comparison, the breakdown of VGOVX, the Vanguard Emerging Markets Bond Index Fund, really is quite low in credit quality. Morningstar's page an average credit rating of "B" (below investment grade), and, interestingly enough, lower than the category average of "BB."

From Vanguard's web page, "Portfolio" tab:

U.S. Government -0.1%
Aa 7.4%
A 19.2
Baa 30.2
< Baa 43.3

This time, Morningstar's numbers are almost identical to Vanguards. I wonder what's with that -0.1%?
How can the average credit quality be B when over 50% of the fund is investment grade? There is certainly something wrong with morningstar averaging here.

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Re: The Risk of International Bond Investing

Post by nisiprius » Mon Aug 12, 2019 9:09 pm

fennewaldaj wrote:
Mon Aug 12, 2019 7:56 pm
nisiprius wrote:
Sun Aug 11, 2019 8:39 pm
By comparison, the breakdown of VGOVX, the Vanguard Emerging Markets Bond Index Fund, really is quite low in credit quality. Morningstar's page an average credit rating of "B" (below investment grade), and, interestingly enough, lower than the category average of "BB."

From Vanguard's web page, "Portfolio" tab:

U.S. Government -0.1%
Aa 7.4%
A 19.2
Baa 30.2
< Baa 43.3

This time, Morningstar's numbers are almost identical to Vanguards. I wonder what's with that -0.1%?
How can the average credit quality be B when over 50% of the fund is investment grade? There is certainly something wrong with morningstar averaging here.
No, there isn't. Morningstar has a document explaining it which... I can't seem to find online right now.

Morningstar is doing exactly the right thing. They base their average credit quality is based on the average default rate, not the average of ranked letter grades.

The problem is that default rates are highly nonlinear with respect to ratings. Morningstar uses this table:

Image

To make the example as simple, imagine a bond fund that consists of 50% AAA bonds and 50% B bonds. If we interpret this by averaging ranks, we get an average somewhere between BBB and A. But that is seriously misleading and makes the credit quality look much higher than it really is. It implies a default rate of less than 5%.

In reality, the portfolio has a default rate of 49.44% + 0% / 2 = exactly 24.72%. That's five times as high as a BBB rating implies.

What Morningstar does is, first, convert ratings to default rates, then average the default rates, then reinterpret the average default rate as a letter-grade rating according to a second table:

Image

So in the 50% AAA, 50% B, the default rate of 24.72% translates to an average credit quality of BB. And given default rates of 5% for BBB, 17.78% for BB, and 49.44% for B, clearly BB is the best choice of the three for representing the average credit quality of the portfolio as a whole.
Last edited by nisiprius on Mon Aug 12, 2019 9:13 pm, edited 1 time in total.
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Re: The Risk of International Bond Investing

Post by grabiner » Mon Aug 12, 2019 9:13 pm

fennewaldaj wrote:
Mon Aug 12, 2019 7:56 pm
nisiprius wrote:
Sun Aug 11, 2019 8:39 pm
By comparison, the breakdown of VGOVX, the Vanguard Emerging Markets Bond Index Fund, really is quite low in credit quality. Morningstar's page an average credit rating of "B" (below investment grade), and, interestingly enough, lower than the category average of "BB."

From Vanguard's web page, "Portfolio" tab:

U.S. Government -0.1%
Aa 7.4%
A 19.2
Baa 30.2
< Baa 43.3

This time, Morningstar's numbers are almost identical to Vanguards. I wonder what's with that -0.1%?
How can the average credit quality be B when over 50% of the fund is investment grade? There is certainly something wrong with morningstar averaging here.
I posted the explanation above:
grabiner wrote:
Sat Aug 10, 2019 3:25 pm
Bond grades do not average the way grades average in school, because the default risk difference between BBB and BB is more than the difference between AAA and BBB. Morningstar averages the estimated default risk of all the bonds in the fund, and then converts it back to a grade, so that a fund which was 75% AAA (near-zero risk) and 25% BB (20% ten-year default risk) would rate BBB (5% ten-year default risk).
I don't trust the M* data, though; M* says that all the non-investment-grade bonds are below B, probably because Vanguard doesn't break down the 43% that is below Baa. A fund with 57% investment-grade bonds and 43% bonds rated CCC or lower would have an overall rating of B, but a fund with 57% investment-grade bonds and 43% lower-rated bonds which are mostly B and BB would have an overall rating of BB.
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Re: The Risk of International Bond Investing

Post by fennewaldaj » Mon Aug 12, 2019 10:25 pm

grabiner wrote:
Mon Aug 12, 2019 9:13 pm

I don't trust the M* data, though; M* says that all the non-investment-grade bonds are below B, probably because Vanguard doesn't break down the 43% that is below Baa. A fund with 57% investment-grade bonds and 43% bonds rated CCC or lower would have an overall rating of B, but a fund with 57% investment-grade bonds and 43% lower-rated bonds which are mostly B and BB would have an overall rating of BB.
Thanks for the explanation Nisiprius and grabiner. Its weird they don't break down the bonds below investment grade. They do for their active EM bond fund.

https://investor.vanguard.com/mutual-fu ... file/VEMBX

And even here you have 8% Not rated bonds which I am guessing are counted as CCC and below but that may overstate their default risk (though I guess the thing with NR bonds is you really don't know)

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Re: The Risk of International Bond Investing

Post by fortyofforty » Tue Aug 13, 2019 6:29 am

One would tend to believe increasing diversification decreases overall risk, whether in equities or debt. One would also tend to believe that higher risks should be rewarded with higher returns, over time, whether in equities or debt.
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Re: The Risk of International Bond Investing

Post by nisiprius » Tue Aug 13, 2019 7:24 am

fortyofforty wrote:
Tue Aug 13, 2019 6:29 am
One would tend to believe increasing diversification decreases overall risk, whether in equities or debt. One would also tend to believe that higher risks should be rewarded with higher returns, over time, whether in equities or debt.
A problem here is that a US investor investing dollars in a Euro-denominated bond is incurring currency risk that a Eurozone investor does not take. In some sense it is unnecessary risk.

The acknowledged risks of international investing are often handwaved away with the statement that the efficient market will reward that risk, but how does that work? How does "the" marketplace reward risk when it isn't really one marketplace and not all investors experience the same degree of risk? Do Eurozone investors reward US investors for taking risk that's only incurred by US investors? Do Eurozone investors get undeserved return from US investors only being willing to pay lower prices because of the higher risk for them?

In a hypothetical case of a galleon-denominated asset where the only investors in it are US investors using dollars and incurring the exchange rate, then, sure.
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Re: The Risk of International Bond Investing

Post by nisiprius » Tue Aug 13, 2019 7:35 am

Vanguard's "portfolio" tab for BNDW has been fixed.

Image

My comparisons of calculated breakdown by credit grade, what Vanguard is showing now, and what Morningstar is showing now. (Morningstar counts U.S. Government securities as AAA, so I combined them in the right three columns. I'm going to call these "the same" and have no interest in trying to figure out why it's not absolutely exact.

Image

For those curious, I had reported the problem to Vanguard by way of an email address published on the Vanguard website, for a person with a job description that seemed relevant to the situation.

I also verified Morningstar's calculation of average credit quality. Using the tables I posted above, the "relative default rate" was 43.27% x 0 + 15.35% * 0.56 + 19.25% * 2.22 + 22.15% * 5 = 1.62. Using the second table, 1.62 translates to "A," and in fact is toward the lower-default, higher-quality end of the A's.
Last edited by nisiprius on Tue Aug 13, 2019 7:47 am, edited 2 times in total.
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Re: The Risk of International Bond Investing

Post by bck63 » Tue Aug 13, 2019 7:40 am

nisiprius wrote:
Tue Aug 13, 2019 7:35 am
Vanguard's "portfolio" tab for BNDW has been fixed.
That is really awesome. Great job. So as the OP, I'll ask again. Given the corrected credit ratings, does it make sense to just invest in the entire world bond market?

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Re: The Risk of International Bond Investing

Post by fortyofforty » Tue Aug 13, 2019 9:26 am

nisiprius wrote:
Tue Aug 13, 2019 7:24 am
fortyofforty wrote:
Tue Aug 13, 2019 6:29 am
One would tend to believe increasing diversification decreases overall risk, whether in equities or debt. One would also tend to believe that higher risks should be rewarded with higher returns, over time, whether in equities or debt.
A problem here is that a US investor investing dollars in a Euro-denominated bond is incurring currency risk that a Eurozone investor does not take. In some sense it is unnecessary risk.

The acknowledged risks of international investing are often handwaved away with the statement that the efficient market will reward that risk, but how does that work? How does "the" marketplace reward risk when it isn't really one marketplace and not all investors experience the same degree of risk? Do Eurozone investors reward US investors for taking risk that's only incurred by US investors? Do Eurozone investors get undeserved return from US investors only being willing to pay lower prices because of the higher risk for them?

In a hypothetical case of a galleon-denominated asset where the only investors in it are US investors using dollars and incurring the exchange rate, then, sure.
If I own Eurozone equities, I am also exposed to currency risk. The same arguments work--and don't work--for equities as well as bonds.
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Re: The Risk of International Bond Investing

Post by grabiner » Tue Aug 13, 2019 8:05 pm

nisiprius wrote:
Tue Aug 13, 2019 7:24 am
fortyofforty wrote:
Tue Aug 13, 2019 6:29 am
One would tend to believe increasing diversification decreases overall risk, whether in equities or debt. One would also tend to believe that higher risks should be rewarded with higher returns, over time, whether in equities or debt.
A problem here is that a US investor investing dollars in a Euro-denominated bond is incurring currency risk that a Eurozone investor does not take. In some sense it is unnecessary risk.
However, Vanguard hedges its international bond funds, eliminating this issue.
The acknowledged risks of international investing are often handwaved away with the statement that the efficient market will reward that risk, but how does that work? How does "the" marketplace reward risk when it isn't really one marketplace and not all investors experience the same degree of risk?
Currency risk is not rewarded by the market because of this asymmetry. This is why most recommended stock portfolios are 60-80% US, even though the US is about half the world market.

Other risks are more symmetric, and thus are rewarded. Since most investors expect emerging markets, or small-cap stocks, to be riskier, they should invest only at prices which give higher expected returns.
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Re: The Risk of International Bond Investing

Post by arcticpineapplecorp. » Tue Aug 13, 2019 8:47 pm

willthrill81 wrote:
Sun Aug 11, 2019 9:31 am
grabiner wrote:
Sun Aug 11, 2019 8:20 am
willthrill81 wrote:
Sat Aug 10, 2019 4:36 pm
Hmm...Extra credit risk with VTABX vs. VBTLX for only an 8 basis point higher SEC yield + uncompensated currency risk = A big 'uh uh' from me.
Vanguard hedges away the currency risk; this is why the two funds have similar volatility.
I wasn't aware that it was a hedged bond fund. Thanks.
yep, right here on the main page:
source: https://investor.vanguard.com/mutual-fu ... view/vtabx

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Re: The Risk of International Bond Investing

Post by Dandy » Wed Aug 14, 2019 7:07 am

When it comes to fixed income I don't see the NEED for much international bond diversity at least approaching a global level. Fixed income is usually for portfolio stability/safety vs growth or even high income. If that is the case it seems there are ample US choices from corporate, FDIC, state munis, or US Government including inflation protected securities. For most I see International bonds as a possible sub allocation e.g. 10%? if wanted.

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