Can you please simplfied this in a simple way of understanding the interpretatio
ID: 2820274 • Letter: C
Question
Can you please simplfied this in a simple way of understanding the interpretation of this
--
The graph above illustrates the volatility difference between international bond ETFs with currency risk versus their currency risk-free counterpart. Vanguard’s Total International Bond ETF (BNDX) hedges out the currency risk through currency forwards. In contrast, the iShares International Treasury Bond ETF, IGOV, keeps the currency volatility intact. The daily volatility inherent to IGOV is more than twice that of BNDX.
---
The sharp increase in volatility because of currency fluctuations applies to emerging market ETFs, as well. The Vanguard emerging market government bond ETF, VWOB, eliminates currency risk by investing in dollar denominated government bonds issued by emerging markets. The iShares emerging markets bond ETF, LEMB, likewise tracks emerging market sovereign bonds but includes currency risk by investing in bonds denominated in the local currency. The local-currency version has nearly twice the volatility of the dollar denominated version.
Minimal Currency Risk With Currency Risk 75% -50% 25% 0.0% BNDX IGOV VWOB LEMB 1 International Developed Bonds ntional Emerging Bonds Betterment Source: Daily total returns data from 2013-01-01 to 2015-01-17Explanation / Answer
Emerging Market bonds denominated in local currency or more perceptible to currency risk than the bonds denominated in dollar. This led to more volatility in returns for local currency bond ETFs than their dollar counterparts. This happens because Emerging markets are vulnerable to higher market risk which reflects in their currency value. If emerging market currency is in higher demand their value appreciates and gives higher returns in comparison to dollar notional bonds. For eg. Suppose a US investor invests in these two bonds:
1. Bond A – Face value INR 5000 and Annual coupon 6%, 5 Year
2. Bond B - Face value $100 and Annual coupon 4%, 5 Year
Let’s assume $1 = INR 50, so these bonds are equivalent in Face value term initially. Now, if one year later if INR has depreciated to $1 = INR 55. This will have a negative impact on Bond A returns as it will reduce the net return rate when converted back to USD((0.06x5000/55)/100) = 5.45% while the returns on Bond B will remain 4% as it is denominated in USD itself. Similarly, if INR is appreciate to $1 = INR 45 it will positively impact the return. This shows why the bonds denominated in Emerging market currency are more volatile than the Bond denominated in USD. That’s why we see lower volatility in BNDX and VWOB(not exposed to emerging market currency risk) in comparison to IGOV and LEMB(exposed to emerging market currency risk). The other factors that impact the return are the interest rate itself when the coupons are determined by floating interest rate and are not fixed. In such cases the announcement by Central banks such as FED, RBI etc impacts the return of the bonds. If FED increases liquidity by decreasing interest rate investors look for more attracting emerging market currencies which offer higher returns as emerging market requires foreign funding for their growth. In times of liquidity tightening such as now FED increases interest rates which have a detrimental effect on emerging market currency as investors pull back their money from emerging market securities to invest in US itself as interest rates are more attractive in US and led to emerging market currency depreciation which reduce the returns on local currency bonds. To reduce the flight of dollars out of emerging market, emerging market country increase their interest rates which might not be same for all some might increase it by small amount some by very big amount depending upon the level of impact. This led to more volatility in local currency denominated bonds.