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  • There are two main types of fixed income risks that investors should consider diversifying: credit and interest rate.
  • U.S. investors can eliminate the need for diversification of credit risk by limiting their holdings to those that carry the full faith and credit of the U.S. government.
  • When limiting holdings to U.S. government credits, in terms of credit risk, international diversification doesn't provide any benefit.

Today begins a two-part series on international bonds and whether or not they belong in your portfolio.

Broad diversification of risk is one of the prudent rules of investing - since it's the only free lunch in investing, you might as well eat as much of it as you can. For equity investors, an important step in reducing the overall risk of equities is to include a very significant allocation of international equities in the portfolio. Both the historical evidence and the logic of diversification suggest that investors should allocate as much as 50 percent of their equity holdings to international equities (today, the U.S. share of the global stock market capitalization is well below 50 percent), including a significant allocation to emerging market equities -- since they make up about 13 percent of global market capitalization. It seems logical, therefore, that investors should also consider allocating a significant portion of their fixed income portfolios to international securities. This is the issue we will now consider.

We begin with understanding that there are two main types of fixed income risks that we might want to diversify: credit and interest rate risk. U.S. investors can eliminate the need for diversification of credit risk by limiting their holdings to those that carry the full faith and credit of the U.S. government. Thus, in terms of credit risk, international diversification doesn't provide any diversification benefit to investors that choose that route. For those that do take some credit risk, the U.S. capital markets are so broad and deep that investors can easily obtain broad diversification without having to add international assets. Thus, we can conclude that while international fixed income investing has intuitive appeal, at least from the perspective of credit risk, there's no need to look abroad.

That leaves us with the following question: Is there a potential diversification benefit in terms of interest rate risk? The answer, as you will see, is that it depends. It depends on whether the international bond is a U.S. dollar-denominated bond or if it is denominated in a foreign currency. If the instrument is a U.S. dollar bond, its price movement (other than a movement caused by a change in credit risk) will reflect the movement in U.S. interest rates. Thus, no diversification benefit, in terms of interest rate risk, is provided. On the other hand, if the issue is denominated in a foreign currency, any price movement (in foreign currency terms) caused by interest rate changes will come from changes in the level of interest rates in the country of which the currency is denominated, and not from changes in U.S. rates. The bond markets of various countries don't move in the same direction or by similar amounts at the same time. Sometimes, U.S. bond markets are rallying (interest rates falling), while foreign bond markets are falling. And sometimes, the reverse is true. Thus, owning bonds denominated in foreign currencies can provide a diversification benefit. However, in this case, the benefit comes at the price of accepting currency risk - the risk that a foreign currency will fall in value relative to the dollar (of course, it can also rise in value). We need, then, to consider the issue of currency risk.

The issue of currency risk is a complex one. We begin by understanding that foreign currency risk is neither good nor bad. It is also important to understand that currency risk is a different type of risk than equity risk, credit risk, or duration risk. Unlike these risks, currency risk has no expected return, and therefore, has no risk premium. But the addition of currency "risk" can reduce the volatility of a portfolio, since currency risk reduces the correlation of returns between assets. Thus, you reduce volatility without reducing expected returns. Hence, currency risk can be a good, not a bad, thing. This is certainly true when it comes to equity investing. With equities, we seek to own assets with low correlation to each other. If an investor were to hedge the currency risk involved in owning foreign stocks (by selling the currency forward in the foreign exchange market), they would be increasing the correlation of returns of their equity holdings, undoing one of the benefits of diversification. Thus, when it comes to owning foreign equities, the strategy should be to not hedge currency risk. A different perspective is, however, needed when it comes to international fixed income securities.

Consider that the main purpose of fixed income assets is to either create a safety net of highly stable assets that allow us to take equity risk while sleeping well, or to create a highly stable stream of income needed to provide a desired lifestyle with a minimum amount of risk. Because currency values relative to the U.S. dollar can be volatile, owning foreign currency-denominated bonds can increase the volatility of both the value of the asset and the income stream we desire to provide us with stability. Thus, it would seem that owning a foreign currency-denominated bond would be at odds with our objective of stability. Fortunately, there is a simple solution - the currency risk can be hedged in the foreign currency markets. These markets are about the most liquid in the world, and as long as one limits holdings to the currencies of the major developed markets (e.g., Canada, France, Germany, Japan, the U.K., etc.), the cost of hedging will be minimal. That is, it will be minimal if you are an institutional investor with access to the wholesale markets. Hedging currency risk allows investors to receive the benefit of diversification of interest rate risk (thus reducing the volatility of the fixed income portion of our portfolio), thereby reducing the volatility of their fixed income assets. Since we can reduce volatility without reducing expected returns, we have achieved our objective.

Tomorrow, we'll look at a study done by Vanguard and wrap up the topic.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Should You Include International Bonds In Your Portfolio? - Part I