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
