The Role of International Bonds in Investing
While individuals have long been told to diversify their stock investments between the domestic and international market segments, the advice encouraging geographic diversification in bonds is much less prominent. As a result, many U.S. investors hold bond portfolios that are heavily – if not fully – tilted toward the domestic market. However, the mutual fund firm T. Rowe Price points out on its website that “foreign bond markets represent 60% of the available fixed income investment opportunities worldwide, including bond issues in emerging economies and non-government entities, such as European corporations.” T. Rowe also notes that, as of 2012, “although the U.S. bond market has been generally attractive for investors, it was the top-performing market only twice in the last 15 years.” Investors who only hold domestic bonds therefore may be missing out on the majority of the fixed-income universe – even if their bond portfolios are diversified.
Yield: Not What it Used to Be
In the past, international government bonds were a way for investors to pick up some extra yield relative to U.S. Treasuries. Today, however, the yield isn’t substantially higher than investors could earn in domestic government bonds, and in some cases it’s much less. The reason for this is that the various crises of the 2007-2012 have fueled a lengthy “flight to quality” into assets seen as having the lowest risk. Prices rose as investors bid up the government bonds of the largest countries – such as the United Kingdom, Germany, and Switzerland – causing yields to fall. (Keep in mind, prices and yields move in opposite directions). As a result, international developed-market government bonds – as a group – are no longer a particularly compelling source of yield.
In addition, index-related products, such as the SPDR Barclays Capital International Treasury Bond exchange-traded fund, or ETF – which trades under the ticker BWX – tend to have unattractive yields due to the heavy representation of low-yielding Japanese bonds in the global benchmarks.
International Bonds: A Source of Diversification
Like domestic bonds, foreign bonds are subject to both credit risk (i.e., the risk of default) and interest rate risk (sensitivity to prevailing interest rate movements). However, the international economies don’t always move on the same cycle as the U.S. economy – meaning that foreign bonds often provide divergent performance relative to the U.S. market. Consider the year-by-year returns of the BWX exchange-traded fund mentioned above compared to the iShares Barclays 7-10 Year Treasury Bond Fund (ticker:IEF), which invests entirely in U.S. Treasuries:
- 2008: BWX 4.19%, IEF 17.50%
- 2009: BWX 5.43%, IEF -6.59%
- 2010: BWX 3.83%, IEF 9.36%
- 2011: BWX 3.96%, IEF 15.64%
- 2012 (first half): BWX 1.32%, IEF 3.09%
While the returns of BWX have not always beaten those IEF, they have had a large degree of divergence – indicating that they are indeed a source of diversification.
The Impact of Currencies
An important difference between international and domestic bonds is the impact of foreign currency movements. When a fund manager invests in the bonds of another country, he or she must first convert the U.S. dollar into the local currency. As a result, the value of the fund is affected not just by the performance of the bonds in the portfolio, but the currencies in which the bonds are denominated.
The influence of currencies can make international investing somewhat more volatile, but it is as likely to help returns in any given year as it is to hurt. The key benefit is that it allows investors to diversify a portion of their portfolios out of the U.S dollar and into other currencies. This is an additional aspect of diversification that investors would otherwise not have if they kept their fixed income portfolios limited solely to domestic investments. And, by investing in bonds, investors can gain this currency exposure without the risks associated with international equities.
How to Invest in International Government Bonds
Most investors don’t have the time or inclination to do the research necessary to purchase individual foreign bonds, nor are they in a position to open up the type of account needed to do so. As a result, mutual funds such as T. Rowe Price International Bond (RPIBX), PIMCO Foreign Bond (Unhedged) (PFUAX), and Fidelity International Bond Fund (FINUX) are usually a popular choice. Investors also have a growing range of ETFs that provide access to the foreign government bond markets. As always, an individual’s investments should be consistent with their objectives and risk tolerance.
Click here for the full list of non-U.S. bond ETFs.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.