Does Investing in International Bonds Really Provide Diversification?
Stock investors are always told to diversify their holdings, and one of the most popular ways to do this is to invest a portion of an equity portfolio overseas. Since different regions of the world may be on different cycles in terms of their economic growth, central bank policy, etc., owning exposure to international equities can augment a stock portfolio that’s heavily tilted toward the United States.
But does it work this way in bond investing?
The short answer: it can, but you may have to be prepared to take risk.
Here’s why: developed-market international government bonds have had a much higher correlation with the U.S. bond market in recent years, meaning that investors need to move into higher-risk asset classes in order to get meaningful diversification from overseas investments. These include international investment-grade and high-yield corporate bonds, as well as bonds issued by emerging-market nations. For many investors, taking on added risk may not necessarily be a problem. However, for an investor with a low risk tolerance or for whom safety is the top priority, the potential downside of diversifying with international bonds may not be enough to offset the potential benefits.
With this in mind, here’s a look different types of international bond investments and how they can help you diversify a portfolio invested largely in domestic investment-grade bonds.
Developed market international government bonds: Bonds issued by countries such as Germany, the United Kingdom, and Japan tend to have lower risk than most of the international fixed-income options, but they also provide little in the way of diversification benefits.
In recent years, the returns of the asset class have tracked very closely with domestic investment-grade bonds, as detailed here.
One reason for this is that major global central banks have all maintained policies of ultra-low interest rates, dampening any impact from economic divergences among various regions of the world. As long as central banks continue to act in concert to depress rates, developed market international government bonds provide little in the way of diversification benefits. Yields are also extremely low, meaning that the asset class offers minimal return potential.
How to compare historical performance: Go to bigcharts.com and compare the charts of Vanguard Total Bond Market ETF (BND), which tracks the U.S. investment grade market, and SPDR Barclays International Treasury Bond ETF (BWX), which tracks international government bonds, to see how the two compare over various time periods.
Developed market corporate bonds: Unlike international government bonds, international corporate and high yield bonds feature performance characteristics that are independent of the fluctuations in the U.S. investment-grade market. They also provide higher yields, which creates the potential for higher long-term returns. These investments certainly have more risk, so investors need to be prepared for higher volatility. Keep in mind, however, that international corporate bonds aren’t affected by the same set of factors as U.S. investment-grade debt. As a result, the two asset classes may move in opposite directions, which may actually reduce the risk of an investor’s overall portfolio.
How to compare historical performance: Chart BND against SPDR Barclays Capital International Corporate Bond ETF (IBND) and Market Vectors International High Yield Bond Fund (IHY).
Emerging market government bonds: Emerging market government bonds can provide meaningful diversification for a portfolio invested in U.S. investment-grade bonds. Emerging market bonds tend to respond favorably to improving economic growth, whereas domestic, investment-grade bonds do not. Further, emerging market bonds tend to respond differently to headlines, central bank policy, and movements in commodity prices.
For those who own investment-grade bonds, this provides the opportunity to own two asset classes that have different responses to the same set of inputs – the essence of diversification. Keep in mind, however, that emerging debt can have very wide price swings in short-term periods, as outlined here, which mean’s that it’s essential to do your research and make sure you can tolerate the risk.
How to compare historical performance: Chart BND against iShares JPMorgan USD Emerging Markets Bond Fund (EMB).
Emerging market corporate bonds: Emerging market corporates are one of the most volatile segments of the bond market, but they also offer above-average long-term growth potential and effective diversification potential for an investment-grade portfolio. This makes sense logically: a bond issued by an energy company in Poland is going to be affected by a different set of considerations than, for instance, U.S. Treasuries. Although emerging market corporates would undoubtedly suffer during the times at which Treasury yields spike – as was the case in May-June 2013 – over time they will exhibit a below-average correlation with the U.S. bond market. Investors who are looking to diversify their bond portfolios with international bonds can therefore give this asset class strong consideration, but it’s essential to be aware of the potential short-term risks.
How to compare historical performance: Chart BND against WisdomTree Emerging Markets Corporate Bond Fund (EMCB).
The Role of Currencies in International Bond Investing
Currencies also affect the performance of international bond funds, as outlined here. While currency movements tend to even out over time, more so with the developed markets than the emerging markets, they can also lead to meaningful divergences in short-term performance. In this way, a fund that has some or all of its portfolio invested in local-currency bonds will provide even greater diversification than one invested in dollar-denominated debt. This diversification doesn’t just take the form of different performance characteristics than domestic, investment-grade bonds, but it also provides investors the potential benefit of holding a portion of their portfolio in non-dollar assets. (This is a plus in that it helps guard against the possibility of a long-term downtrend in the U.S. dollar.)
The Bottom Line
While developed-market international government bonds don’t provide much in the way of diversification benefits, there are plenty of ways that investors can use non-U.S. investments to diversify their bond portfolios. As always, do your research to make sure you understand the potential risks.
But does it work this way in bond investing?
The short answer: it can, but you may have to be prepared to take risk.
Here’s why: developed-market international government bonds have had a much higher correlation with the U.S. bond market in recent years, meaning that investors need to move into higher-risk asset classes in order to get meaningful diversification from overseas investments. These include international investment-grade and high-yield corporate bonds, as well as bonds issued by emerging-market nations. For many investors, taking on added risk may not necessarily be a problem. However, for an investor with a low risk tolerance or for whom safety is the top priority, the potential downside of diversifying with international bonds may not be enough to offset the potential benefits.
With this in mind, here’s a look different types of international bond investments and how they can help you diversify a portfolio invested largely in domestic investment-grade bonds.
Developed market international government bonds: Bonds issued by countries such as Germany, the United Kingdom, and Japan tend to have lower risk than most of the international fixed-income options, but they also provide little in the way of diversification benefits.
In recent years, the returns of the asset class have tracked very closely with domestic investment-grade bonds, as detailed here.
One reason for this is that major global central banks have all maintained policies of ultra-low interest rates, dampening any impact from economic divergences among various regions of the world. As long as central banks continue to act in concert to depress rates, developed market international government bonds provide little in the way of diversification benefits. Yields are also extremely low, meaning that the asset class offers minimal return potential.
How to compare historical performance: Go to bigcharts.com and compare the charts of Vanguard Total Bond Market ETF (BND), which tracks the U.S. investment grade market, and SPDR Barclays International Treasury Bond ETF (BWX), which tracks international government bonds, to see how the two compare over various time periods.
Developed market corporate bonds: Unlike international government bonds, international corporate and high yield bonds feature performance characteristics that are independent of the fluctuations in the U.S. investment-grade market. They also provide higher yields, which creates the potential for higher long-term returns. These investments certainly have more risk, so investors need to be prepared for higher volatility. Keep in mind, however, that international corporate bonds aren’t affected by the same set of factors as U.S. investment-grade debt. As a result, the two asset classes may move in opposite directions, which may actually reduce the risk of an investor’s overall portfolio.
How to compare historical performance: Chart BND against SPDR Barclays Capital International Corporate Bond ETF (IBND) and Market Vectors International High Yield Bond Fund (IHY).
Emerging market government bonds: Emerging market government bonds can provide meaningful diversification for a portfolio invested in U.S. investment-grade bonds. Emerging market bonds tend to respond favorably to improving economic growth, whereas domestic, investment-grade bonds do not. Further, emerging market bonds tend to respond differently to headlines, central bank policy, and movements in commodity prices.
For those who own investment-grade bonds, this provides the opportunity to own two asset classes that have different responses to the same set of inputs – the essence of diversification. Keep in mind, however, that emerging debt can have very wide price swings in short-term periods, as outlined here, which mean’s that it’s essential to do your research and make sure you can tolerate the risk.
How to compare historical performance: Chart BND against iShares JPMorgan USD Emerging Markets Bond Fund (EMB).
Emerging market corporate bonds: Emerging market corporates are one of the most volatile segments of the bond market, but they also offer above-average long-term growth potential and effective diversification potential for an investment-grade portfolio. This makes sense logically: a bond issued by an energy company in Poland is going to be affected by a different set of considerations than, for instance, U.S. Treasuries. Although emerging market corporates would undoubtedly suffer during the times at which Treasury yields spike – as was the case in May-June 2013 – over time they will exhibit a below-average correlation with the U.S. bond market. Investors who are looking to diversify their bond portfolios with international bonds can therefore give this asset class strong consideration, but it’s essential to be aware of the potential short-term risks.
How to compare historical performance: Chart BND against WisdomTree Emerging Markets Corporate Bond Fund (EMCB).
The Role of Currencies in International Bond Investing
Currencies also affect the performance of international bond funds, as outlined here. While currency movements tend to even out over time, more so with the developed markets than the emerging markets, they can also lead to meaningful divergences in short-term performance. In this way, a fund that has some or all of its portfolio invested in local-currency bonds will provide even greater diversification than one invested in dollar-denominated debt. This diversification doesn’t just take the form of different performance characteristics than domestic, investment-grade bonds, but it also provides investors the potential benefit of holding a portion of their portfolio in non-dollar assets. (This is a plus in that it helps guard against the possibility of a long-term downtrend in the U.S. dollar.)
The Bottom Line
While developed-market international government bonds don’t provide much in the way of diversification benefits, there are plenty of ways that investors can use non-U.S. investments to diversify their bond portfolios. As always, do your research to make sure you understand the potential risks.
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