Today we continue our discussion on international bonds. We'll begin with a Vanguard study.
Vanguard reached the same conclusions we discussed in yesterday's post in their February 2014 research paper "Global fixed income: Considerations for U.S. Investors." The paper states:
- For the average investor seeking to further mitigate volatility in a diversified portfolio, foreign bonds can play such a role.
- For investors looking to add exposure to foreign bonds, we show the substantial benefits of hedging the impact of foreign exchange movements.
- While the bonds of any one country maybe more volatile than comparable U.S. bonds, an investment that includes the bonds of many countries and issuers could benefit from imperfect correlations across those issuers.
- Our analysis shows that in aggregate, and with the appropriate hedging of currency risk, an investment in the broad international bond market can be less volatile than an investment in the broad U.S. bond market.
On the other hand, Vanguard noted that the volatility of currencies can overwhelm any diversification benefit that international bonds may bring to a diversified portfolio. They concluded: "Based on our findings, we believe that most investors should consider adding hedged foreign bonds to their existing diversified portfolios."
Individuals considering owning international fixed income assets should understand that in order to effectively diversify interest rate risk (and credit risk), an investor would need to own bonds denominated in several currencies. The most cost effective way to accomplish this objective is to own a low cost mutual fund. In addition to the diversification benefit a mutual fund provides, another reason to utilize a fund is that the cost of hedging the currency risk would almost certainly be greater for individuals than it is for institutional investors. The difference is a result of the markup a retail investor would pay over the wholesale (or interbank price). As is the case with the market for municipal bonds, in the foreign exchange markets, size matters. That is, small trades pay large markups. And the interbank foreign exchange market trades in blocks of at least $1million.
To summarize, owning currency-hedged foreign denominated bonds is an effective way to gain exposure to foreign interest rate cycles that are different from U.S. interest rate cycles without taking the currency risk. Investors seeking the diversification benefit, and possibly somewhat higher returns of investing in high-grade foreign bonds, should do so only through mutual funds that can effectively diversify the risk of owning a single issuer, and also hedge the foreign currency risk in a low cost manner. It should also be a passively managed fund, since there's no evidence of ability of active managers to add value in this asset class. The fund would also have to fit the desired maturity structure of the investor. I'd also recommend that for most investors maturities should be limited to the short- to intermediate-term. In addition, the fund should limit its holdings to the two highest investment grades (AAA and AA). The major rating agencies do provide ratings on foreign bonds as well as on U.S. bonds. And Morningstar, for example, has a service that allows you to check the credit quality of the holdings of a bond mutual fund.
Before concluding this section, a word of caution is warranted. The credit ratings of the bonds of foreign governments can change very rapidly. Just two years before the Asian crisis that hit the markets in 1998, the credit rating of Malaysia was AA+, and the rating of Thailand was AAA. This warning is not meant to frighten investors away from considering owning international fixed income assets. However, it does serve two important purposes. The first is that prudent investors always keep in mind that even the highly unlikely (a AAA-rated bond going into default) isn't impossible. Thus, diversification of risk is an extremely important part of a prudent strategy. And second, with the assets we want to provide either stability of value and/or stability of cash flow, we should seek to minimize credit risk. With that in mind, the recommendation is to limit fixed income investments to the major industrial countries, and to limit even their maturities to the short to intermediate term (credit risk increases as the investment horizon increases).
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.