Historically, American investors have displayed a strong home country bias when it comes to fixed income, investing more in U.S. bonds than international bonds. According to data on U.S.-based ETFs and open-end mutual funds from Morningstar Direct, $200.3 billion was invested in international bond categories, while $3.6 trillion was in U.S. bond categories, as of year-end in 2015.
Why is there such a big difference? Some investors are just more comfortable investing in markets that they know better. Others may shy away from international bonds because currency fluctuations between the U.S. dollar and foreign currencies can lead to higher return volatility. Many of us buy bonds as a potential source of portfolio diversification - e.g., to offset dramatic price swings from equity markets-and hesitate to add foreign currency risk.
A rising rate environment is a challenge for U.S. bonds
Looking ahead, it will likely not be easy for U.S. bonds to deliver good returns after the recent multi-year rally. Bond investors today are faced with low yields. There is also the prospect of price loss as the Federal Reserve (Fed) has started raising its benchmark lending rate amid a stronger U.S. economy (a bond's yield moves in the opposite direction of its price). Although U.S. interest rates could stay lower than in previous rate cycles as Fed policy very slowly normalizes, investors remain concerned about the impact of rate increases on their fixed income returns. As a result, future bond returns are likely to be driven more by income and less by price appreciation.
It's a big world out there
Overseas, the fixed income market may offer a wider opportunity set, which is important considering how hard it is to source income today. As I travel from country to country this summer, I am getting an on-the-ground view of this low yield world and seeing first-hand the variety of economic and monetary policies at work that may differ from those of the United States. For example, while the United States is tightening its monetary policy, the central banks of Europe and Japan both have launched aggressive stimulus measures since 2014 to jumpstart economic growth. These stimulus measures have driven bond yields in Europe and Japan lower and bond prices there higher, and could continue to do so (source: Bloomberg).
At any given time, different countries are experiencing different levels of economic growth. In response, these countries may implement different economic and monetary policies. As a result, their bonds may offer a mixture of potential income and capital appreciation opportunities that may differ from those in the United States.
More than one flavor
If a portfolio's fixed income allocation is entirely made up of U.S.-only bonds, it likely means that if U.S. bonds have had a bad year, so has the portfolio's fixed income exposure. But if a portfolio holds a basket of bonds from different countries, bond prices of one country may be rising while bond prices of another may be falling. This way, price movements of bonds from different countries can help offset one another. While diversification does not fully protect against market risk, it can potentially make a portfolio less prone to dramatic swings.
For investors worried about foreign currency risk, currency hedging could be the answer. Currency impact can be managed by hedging local currencies back into U.S. dollar, allowing investors to potentially earn local market yields and take advantage of potential local bond price appreciation, with less currency fluctuations. And perhaps more importantly, some hedged international bond exposure can potentially reduce a portfolio's overall volatility amid rocky markets.
Expand your fixed income opportunity
Investing in international bonds, especially currency hedged bonds, could provide additional income opportunities and could also lower overall portfolio risk. Investors may want to think about taking a percentage of their U.S. core bond fund exposure and allocating it to a hedged international bond market index fund, such as the iShares Core International Aggregate Bond ETF (NYSEARCA:IAGG).
This post originally appeared on the BlackRock Blog