Diversifying Your Portfolio with Foreign Bonds

In 2013, Vanguard Group decided to shift certain bond holdings from a focus on US bonds to foreign debt. To date, it seems like the change has paid dividends, seeing a whopping 423.3 billion in combined assets. In addition to its billion dollar payouts, the Wall Street Journal reports that those same mutual funds saw an average 5.2% rate of return. That’s a 1.8 percent higher rate of return than index funds focused on U.S. bond markets.

Foreign bonds have become a valuable way of diversifying your porftfolio

The primary reason to invest in international bonds is portfolio diversification. Including exposure to various national economies as well as interest rate environments are great ways to reduce risk in one’s personal portfolio. In fact, according to Gregg Fisher of Investment-Management Firm Gerstein Fisher, a global fixed-income portfolio has resulted in better risk-adjusted returns over most longer periods. International bond factors are also largely driven by factors that are usually unrelated to those that drive the U.S. bond market. As a result, buying international bonds can drastically reduce the volatility in a portfolio.

Since being added to Vanguard’s target-date and target-risk funds, the foreign bond fund has paid off successfully. “[The foreign-bond fund] has done everything we could have hoped it would… [but] had the performance been flipped in the other direction, we would not be worried about it at all.” says Fran Kinniry, principal for Vanguard’s investment strategy group.

However some U.S. investors who diversified their bond holdings with global debt may have instead hurt their performance. Why? Hedging becomes increasingly important when dealing with foreign currencies. Unlike Vanguard, many of these foreign-bond funds forget the very crucial step of hedging their exposure to fluctuating currency rates. Such foreign-exchange trends have the potential to hurt returns for U.S. investors holding foreign debt.

Morningstar, by contrast, has tracked opposing results. It reveals that the average world-bond funds lagged behind conventional corporate and other investment-grade U.S. bonds. These foreign-bonds returned just a lowly 0.6% a year on average over the past three years, and 4.2% on average over the past ten years. U.S. intermediate-term bonds still held higher returns at 4.6%. “[Emerging market bonds] have a lot of currency risk and a fair amount of credit risk” Kathy Jones of Charles Schwab & Co..

Nevertheless, the possibility of near-term losses on U.S. bonds is growing. For investors, getting exposure to different national economies and interest-rate environments can be a particularly good way of protecting wealth, and generating healthy returns.

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Originally published at nicholasfainlight.net.

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