Indexfundfan\’s blog (new URL is Indextown.com)

July 16, 2006

The case for foreign bonds

Filed under: Investing — indexfundfan @ 2:43 pm

Investors are often advised to allocate a portion of their portfolio (typically ranging from 20% to 50%) to international equities for diversification. Does this same advise apply to foreign bonds? Below are some of the comments I found. The conclusion might surprise you.

Annette Thau, the author of the highly respected book “The Bond Book”, has the following to say in the second edition of the book. According to her, arguments for foreign bonds might include

1) diversification — this argument has some merits when applied to very large bond portfolios, like those of pension funds of insurance companies. For individuals, if the primary objective is for safe, predictable income, this argument becomes irrelevant.

2) higher total return — while it is true that during certain time periods, foreign bonds have earned higher returns, these periods are only known on hindsight, with good timing and the selection of the correct foreign currency.

3) hedge against the falling dollar — if you can accurately predict the falling dollar, a strong case can be made for international bonds.

Bottom-line — if your bond allocation is used as a portfolio safety anchor, then the case for international bonds is not very convincing. But, if your portfolio is large or if you feel that you have sufficient information to speculate in an informed manner, including international bonds may make sense. But in any case, the allocation should be limited to no more than 10% or 20% of the bond portfolio.

David Swensen, in the book “Unconventional Success” says “foreign bonds offer little of value to U.S. investors”:

1) while foreign exchange exposure may produce the benefit of additional diversification and reduce portfolio risk, investors should however obtain foreign exchange exposure through an asset class expected to produce superior returns, namely foreign equities, instead of using foreign bonds.

2) foreign currency positions, per se, promise a zero expected return, so we can expect similar returns between foreign and U.S. bonds. But, unhedged foreign bonds fails to provide the same protection against financial crisis as US Treasury securities since the impact of foreign exchange in the crisis is unknown.

3) holders of domestic treasury bonds can expect fair treatment from their government since governments normally find no reason to disadvantage their citizens. But, in certain circumstances, foreign governments may realign their interest to the detriment of foreign investors (e.g. exchange controls enacted by Malaysia during the Asian economic crisis, note: example is mine).

Larry Swedroe, in his latest book “The Only Guide to a Winning Bond Strategy You’ll Ever Need”, thinks that the negatives in holding foreign bonds appear to substantially outweigh the positives. However, having said that, Larry also mentions that the only reason for holding foreign bonds will be a potential diversification benefit in terms of interest rate risk:

1) Since interest rates in the U.S. and foreign nations typically do not move in the same fashion, there is a diversification benefit to holding foreign bonds, but this comes at the price of currency risk. This currency risk can be minimized with bond funds that hedge the currency. There is a small cost for hedging.

2) It is therefore OK to invest in foreign bonds if you can get it in a low-cost vehicle and also provided the fund hedges its currency positions and invests in only AA and AAA investment grade bonds.

Rick Ferri believes that the bond allocation should also be diversified like the equity portfolio. In one of his posts, he tabulates a bond allocation as follows

20% in short government / CD ladder (direct investment)
10% in ten-year TIPS (direct investment)
20% in intermediate corporate (LDQ)
20% in high yield corporate (VWEHX)
20% in long corporate (individual preferred stocks)
10% in emerging market bonds (PYEMX)

DFA’s fixed income strategy has a short section on foreign bonds :

Generally, investors pursue global portfolios in order to diversify. Statistically, diversification should result in lower portfolio volatility due to the combination of uncorrelated assets. The use of non-dollar developed market bonds, however, introduces foreign currency exposure. Currency exposure noticeably increases the volatility of the fixed income portfolio, while there is no reliable evidence to suggest that the expected return of exchange rates is anything other than zero. If volatility is increased with the addition of global assets, the whole purpose of international diversification is defeated. Therefore, we believe currency exposure should be hedged in global bond portfolios.

This view is very similar to Larry’s. DFA also provides two very interesting tables.

a) Risk measure of hedged and unhedged foreign bonds

2006-07-16-hedged-vs-unhedged-bonds.PNG

b) Correlations of hedged foreign bond indices

2006-07-16-foreign-bonds-corr.PNG
In summary, David Swensen does not think adding foreign bonds is necessary. Annette Thau and Larry Swedroe both believe that there might be some benefit of adding some foreign bonds (e.g. 20% of bond allocation). On the other hand, Rick Ferri thinks that it is a good idea to fully diversify the bond allocation, and that includes adding foreign bonds.

Personally, I think having an allocation to investment-grade foreign bonds is optional, but it may be included at up to 30% of the bond allocation for an U.S. investor.

Advertisements

Leave a Comment »

No comments yet.

RSS feed for comments on this post. TrackBack URI

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Blog at WordPress.com.

%d bloggers like this: