Exploit Weak Dollar With a Foreign Bond ETF

If you own foreign stocks or stocks funds, you already know the diversification benefits of international exposure. Those apply to bonds, too. In general terms, keeping a portion of your bond portfolio in foreign issues protects against a falling dollar. Depending on how narrowly you invest, it can also provide exposure to a specific currency that looks to be fundamentally strong.

BWX is a broad-based product with exposure to 17 different countries (13 developed countries and four emerging markets; five if you think of Greece as emerging). The fund allocates large percentages to Japan (22.79%), Germany (12.71%) and Spain (12.16%). The other countries get much smaller weightings from there.

The fund weights Japan heavily because the country has a lot of debt outstanding.

All of that exposure to Japan does mean BWX has a low yield, but not that low. The low rates from Japan are offset to some degree by higher yields from South Africa, Mexico and Poland. The mix of different yielding countries nets out to a current yield for the fund of 3.56% (4.06% for the index less a 0.50% expense ratio).

The average maturity of the fund is 7.6 years and the duration is 5.73% years. To give some frame of reference for yield at that maturity/duration, the iShares Lehman 3-7 Year Treasury Bond Fund, which is a domestic fund, has a yield of 4.39%. BWX's credit quality averages AA2, which should not be surprising or that important, as all the holdings are sovereign debt.

There are a lot of good fixed-income destinations that have little or no representation in BWX, such as Australia, Ireland, Norway and Finland. So, while BWX strikes me as a worthwhile product that can provide exposure to an important asset class, I do not think it works as a stand-alone for foreign bonds.

Buying individual foreign bonds to mix with a broad-based fund like this is probably out of reach for most do-it-yourselfers, because minimum orders tend to be $100,000. And, for now, most of the pooled investment products that invest in this assets class are broad-based developed market closed-end funds or emerging market closed-end funds. However, some of these funds do make concentrated bets on certain volatile, high-yielding countries.

A strategy that could work very well would be to use BWX as a core holding, pairing it with Aberdeen Asia Pacific Income Fund (FAX), which has an usually heavy weighting in Australia and yields 6.73%, and an emerging-market fund like Morgan Stanley Emerging Markets Domestic Debt Fund (EDD), which is heavily weighted toward Brazil and Turkey, yielding 8.93%. I wrote about EDD for Real Money, TheStreet.com's subscription Website, last month.

I think allocating 20% of a bond portfolio to foreign countries is a reasonable approach. Allocating 70% to this portion to the broad-based BWX, 20% to FAX and 10% to EDD would be a simple way to have broad exposure and enhance yield dramatically, versus just buying BWX. Instead if 3.56% from BWX alone the above mix would yield 4.72%, and obviously a more aggressive investor could tweak the mix to take on more volatility and yield.

This is a part of the market where there should be a lot more product development. In addition to other broad-based products in the works, PowerShares will be listing an emerging market bond ETF soon with ticker PCY, State Street has a global TIPS fund in registration and I also expect to see more specialized products, such as regional funds that invest in Oceania, the Nordics and the European continent and perhaps some single-country bond funds for places like the U.K. or Canada.

Owning foreign assets can be thought of as a bet that the dollar will go down. So the biggest risk to owning foreign bonds is that the dollar goes up. While I do believe the dollar will be weaker over the longer term, there will be pockets of dollar strength over shorter period. When that happens, BWX or any other similar product is likely to go down.

Still, ETFs should provide a less volatile way to invest in foreign bonds than closed-end fund. That's because closed-end funds issue a fixed number of shares and prices can fluctuate widely from their net asset value. But ETFs can create new shares when demand soars and breaks up existing shares into their component securities when it falls off. As a result, they don't fluctuate from their net asset values anywhere near as much as closed-end funds.