BNDW ETF: Global bonds are preferable to global equities

Regular readers will be well aware that I believe US bonds will significantly outperform US equities over the next few years, but the recent outperformance of international equities relative to bonds also suggests that international bonds should also outperform. THE Vanguard Total World Bond ETF (NASDAQ:BNDW) is therefore preferable to global stock market indices. The BNDW offers a well-diversified bond portfolio in terms of geographic, sector and credit risk. The 4.7% return far exceeds the return of the MSCI World Equity Index and the ETF faces much less downside risk in the event of a global recession.

The BNDW ETF

The BNDW seeks to track the performance of a broad, market-weighted index that measures the investment performance of US investment-grade bonds and non-US dollar-denominated investment-grade bonds. The ETF is dollar-hedged and made up of equal shares of Vanguard’s total bond market (BND) and the Vanguard Total International Bond Index (BNDX), with geographical exposure therefore strongly oriented towards the United States. In terms of sector exposure, government bonds dominate the ETF, but there is also significant exposure to industrial and financial sector credits. The weighted average maturity is currently 8.9 years while the duration is 7.0 years. The weighted average yield to maturity is 4.7%, while the expense ratio is just 0.05%.

Increasingly attractive international bond yields

The recent rise in international bond yields has significantly improved their long-term return outlook, especially relative to equities, which have soared in recent months. With the exception of Japan, all major NDDB markets are now offering returns above long-term inflation expectations. Even in Europe, where real yields have been deeply negative for more than a decade, the recent surge in yields has restored a positive real yield outlook.

With the dividend yield on international equities falling sharply alongside rising equity prices, bond yields are now higher than equity dividend yields for most NDDB markets. Even in the UK, the recent rise in equities and rising gilt yields have left bond yields on par with the FTSE dividend yield. This marks a major reversal from three years ago, when UK equities yielded as much as 6.4% above 10-year gilts.

4.7% return well above the return of global equities

With US bond yields well above US equity dividend yields, it should come as no surprise that the BNDW’s 4.7% yield far exceeds the MSCI World’s yield. Even with dividend payouts at record highs relative to sales, the MSCI World dividend yield is just 2.1%, meaning bond income is expected to be 2.6pp higher than shares, all other things being equal. It is the highest such spread since November 2007, after which global bonds surged and stocks tumbled.

Over the past decade, MSCI World dividends have grown at an annual rate of 4.6%, and if this were to continue, stocks would outperform assuming the dividend yield did not change. However, growth in developed markets is expected to slow by at least 2 percentage points over the next few years compared to the past decade, which means that fundamental returns for bonds and equities should be roughly equivalent.

BNDW has much less downside risk

Although the expected returns of global equities and global bonds may be similar, the risk-return outlook for bonds is very favorable due to the much shorter duration. For example, if investors were to demand a 1 percentage point higher yield on the BNDW, the ETF price would have to fall by around 7%, which is the current duration. In contrast, a 1pp rise in required returns on the MSCI World would require the dividend yield to rise to 3.1%, forcing stock prices to fall by a third. Global investors have historically demanded around 5% higher returns on equities relative to bonds to compensate for their higher volatility and the risk of losses in precarious economic conditions. This suggests that the current risk premium on equities, which is close to zero, represents a good time for international investors to take some risk off the table.