Do You Need International Bonds In Your Portfolio?

Bonds are supposed to provide both income and stability in your portfolio. International bonds, especially Emerging Markets bonds, are becoming more popular. But do you need them in your portfolio? Respected author/money manager William Bernstein doesn’t think so. From an ETF.com interview:

ETF.com: One thing that puzzled me is that among your recommendations, I don’t see an international bond fund as part of the allocation—even one that’s currency-hedged. Why?

Bernstein: Well, first, there is absolutely no way any rational investor would want an unhedged international bond fund in their portfolio for a very simple reason: Your bonds are your “safe” assets. They are what you are defeasing your retirement with; they are what enables you to sleep at night; they are your liquidity for when you lose your job or for when you want to buy cheap equities or the corner lot from your neighbor who got caught in a liquidity squeeze.

And the unhedged currency exposure with unhedged international bonds is very risky. All you have to do is look to what happened to the euro and the yen in the last crisis—they cratered. That’s a risk you simply don’t want to take.

Now, when you have hedged currency risk as opposed to unhedged currency risk in a bond fund, you’ve got a smaller problem, but it’s still a problem. And that’s when you take foreign sovereign bonds and hedge them back to the dollar—you’ve basically got U.S. bonds.

Maybe you get a tiny bit of extra diversification, but it’s a trivial amount—plus you’re paying higher expenses and higher transactional costs to deal with foreign bonds.

On the other hand, the Vanguard Group apparently does believe that holding international bonds is a worthwhile way to add diversification to your portfolio, as in 2013 they added international bonds to their Target Date Retirement and LifeStrategy all-in-one mutual funds (currently 20% of the total bond allocation). The Vanguard Total International Bond ETF (BNDX) has an expense ratio of 0.20%, while the domestic Vanguard Total Bond Market ETF (BND) has an expense ratio of 0.08%.

As Bernstein puts it, “owning a currency-hedged bond international fund is just basically getting into slightly more expensive U.S. bond exposure.”

Personally, I’m also not convinced that international bonds offers something necessary. Maybe someday that will change. Whenever I’m not convinced, I choose simplicity. Thus, I have never and currently do not own any foreign bonds.

Comments

  1. If you have a full service broker and ask them about Australian corporate bonds for instance, you can get relatively short duration and attractive yields at the same time. Attractive enough to compensate for any swings in exchange rates. Same with bonds in Canada though they tend to have higher premiums so good deals are fewer and farther between.
    I think Bernstein has the typical American prejudice of believing US anything is most reliable and attractive. The US may be the best looking horse in the glue factory but it is little else. I think individual foreign bonds verses bond funds are good investments that bring balance to the fixed income component of your portfolio. Hong Kong, Canada, Australia, New Zealand or European bonds denominated in stable currencies have all been good bets for me over the last 7 years.

    • I’m going to have to respectfully disagree. You are proposing to buy individual bonds from businesses denominated in Australian dollars. So you have individual company default risk, currency exchange risk, bid/ask spread transaction costs, all in addition to the usual interest rate risk. If that individual company defaults, you are out all of your principal for that bond. If one company in a diversified corporate bond fund folds, I may not even notice. I simply don’t think Australian individual corporate bonds are an inefficient market that can be taken advantage of. You might do fine, or you might only do fine until one day you get burnt really bad.

      • As a generic answer I can’t say that your thinking process is incorrect but when you look at banks like ANZ, Westpak,Commonwealth or BNG Bank and Nordic for instance that issue bonds in $AU I hardly think the risk of default is something to worry about. And given that you can get yields of 4.5% – 5% on 3 year bonds the duration risk is much better then anything in the US. As far as exchange rate risk, I agree that’s a gamble. I understand that there is a certain safety in an ETF or Mutual Fund but picking a good corporate or provincial bond is a lot easier then trying to time a stock purchase and offers a much higher yield.

        • The Australian dollar is trading at around $.92 right now, which is much stronger than its historical average as a result of Aussie rates being high relative to U.S. interest rates. The AUD historically has been worth around $.66 and could easily revert to the $.80 or $.70 range in the next three years which would more than wipe out the interest rate differential. Regardless of your view on the AUD, the fact is it will weaken if (and when) U.S. rates rise relative to Australian interest rates, so by being in AUD denominated bonds you have the exact same exposure to rising U.S. rates you would have by being in longer-dated U.S. paper. Yes, U.S. rates have remained low for a long time and could stay low longer, but you could bet on that phenomenon (them staying low) just as easily using longer-term higher-yielding U.S. bonds.

          • Though I’ve done very well with both my $AU and $NZ investments. I agree with your assessment and was just using the $AU to make the broader point that, yes, international bonds make sense in a portfolio and second, that buying individual bonds is in many ways safer and more rewarding then buying them through a bond fund of some kind. Ultimately no one loves my money more then I do, so whether something is passively or actively managed in my mind, its no substitute for being managed by me. Though Jonathan’s blog has inspired to invest in VOX, VWINX and VGK they remain a very small percentage of my total portfolio which are individual bonds I’ve chosen myself.

          • Bernstein’s point bares repeating and emphasizing here again as it’s key to sound portfolio and risk mgmt., and that is that your fixed income investments should provide safety, stability, and balast to your portfolio. If you need a refresher here, just look at the performance of Treasury’s in ’08-’09 to understand this key dynamic.

            The equity side of your portfolio is where you take the risks. You should already have all the currency risk benefits you’d ever need via a globally-diversified stock portfolio. And to Sim’s last point re indiv bonds being safer than via fund or ETF, he also don’t understand how bonds other than Treasurys trade, i.e. transactional costs and the huge advantage institutional investors, who buy in bulk, have here over individual investors. Individual investors get hosed on the concession or mark-up. Not that your broker will EVER tell you about that, as it’s how broker-dealers make good money. Over time, the avg. investor will undoubtedly do better via dividend reinvestment in a low cost fund or ETF. Again, maybe not something you’lkl hear from a broker-dealer.

  2. Willy j says:

    All investments have risks…. Bonds primarily have interest rate risk once you buy a diversified fund. By buying international bonds you are further diversifying the interest rate risk across all countries (not just the U.S.)…. More diversification is the primary reason to buy internatonal bonds…. Bnd and bndx for example are not 100 % correlated.

    I have owned several international bond funds for while and found them to be a good stabilizer over the years.

  3. Tommy Z says:

    While I agree that it makes no sense to buy hedged foreign bonds, I totally disagree with the rest. The whole point of buying UNhedged bonds is to diversify your currency exposure.

    If currencies have and do crash, why would any sane person want to put all their eggs in one basket of US currency? It’s insanity. The dollar is artificially propped up by foreign central banks. Once they stop doing that (and they are already in the early stages of doing that), the dollar has nowhere to go but down.

    • Okay, but all your expenditures are in dollars, are they not? Assuming you are correct and the dollar is going to “crash,” what do you care if your dollars can buy many fewer GBP or JPY, if they still buy the same amount of goods and services here? The reason to have all of your eggs in one basket is because everything you want and need is purchased here on this soil with those exact baskets and you can’t use other baskets to buy anything at all here. Since 2008 the USD has depreciated (crashed) approximately 50% against the AUD and I would bet that most people here didn’t even notice, because their purchasing power is generally unchanged as a result.

  4. Andy…your assumption is that all people are rooted here…. and one of the few advantages of being a US citizen is that travel is still pretty much unlimited and unhampered by Visa requirements….so in fact if there was a major social or economic crises one always has a place to run to if you get out soon enough and already have a portion of your assets abroad. My metaphor is the Holocaust. Why were some people foresighted enough to escape while so many others didn’t want to see what was coming. And is Police State America not coming up in everyone’s rear view mirror? But not to digress…if I came to you and said…hey…invest everything you have with me. I’m $16 trillion in debt on the books, probably $100 trillion in debt off the books. I just lost three wars in a row that cost well over $3 trillion that were funded with debt, everyone in my company is on the take and corruption and incompetence are our core values….would you invest with me? I think not….the United States has taken to the low road to financial ruin and much worse.
    But even that aside…back to the $AU and $NZ and $CAD, your analysis of the situation right now is correct but if you invested in these currencies 5-10 years ago even with current volatility you are still way ahead.
    So I guess everyone can agree to disagree.

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