While U.S. investors have achieved diversification in their domestically focused portfolios mainly through international equities, they are increasingly considering global bonds. In the past decade, there’s been substantial growth and maturation of world bond markets, combined with the ongoing globalization of businesses and capital flow, according to Vanguard.
International bonds now make up more than 35% of the world’s investable assets, and yet many domestic investors have little or no exposure to these securities, the fund family says in a recent research report, which examines the strategic case for an allocation to international bonds by addressing the possible diversification benefits, risks, and costs.
For the average investor seeking to further mitigate volatility in a diversified portfolio, the Vanguard analysts — led by Christopher Philips — find that foreign bonds can play such a role, assuming that the currency risk inherent to this asset class is hedged. Though there is currently not an optimal allocation for all investors, the research shows that having some exposure can be better than having none.
At the same time, however, a home bias in bond portfolios may be defensible on grounds other than the pure question of diversification; thus, the report concludes, investors considering international bonds should “balance the diversification benefits against both the costs involved and the benefits inherent to preserving a core allocation to the U.S. bond market.”
The Vanguard researchers evaluate the historical impact of adding both unhedged international stocks and unhedged international bonds to a 60% U.S. stock/40% U.S. bond portfolio.Portfolio volatility, defined as the annualized standard deviation of monthly returns, is found to rise when any amount of unhedged international bonds is added to any combination of U.S. stocks, international stocks, and U.S. bonds vs. a portfolio without international bonds.
In fact, the least volatile portfolio, according the research, has no international bonds at all — it is 42% U.S. stocks, 18% international stocks, and 40% U.S. bonds. Given an objective of minimizing volatility, the analysis shows that as investors increase their allocation to unhedged international bonds, international stocks may be replaced, so that an investor allocating 100% of a fixed-income portfolio to international bonds might want to consider a 0% allocation to international equities.International fixed-income securities make up a significant portion of the global investable market today, the research concludes. While investors in international bonds are exposed to the risk of interest-rate movements, the political landscape, and the economies of many different markets, the Vanguard analysis reveals that the primary factors driving international bond prices are relatively uncorrelated to the same U.S. factors, which implies a diversification benefit.
To make the strategic decision to include international bonds in a diversified portfolio, the authors explain, advisors and investors should weigh the trade-offs among several factors: the potential to reduce portfolio volatility, exposure to the largest global asset class, the costs of implementation, and the investor’s/advisor’s views on the future path of the U.S. dollar. Based on the fund group’s findings, its analysts believe that most investors should consider adding hedged foreign bonds to their existing diversified portfolios.