Should International Bonds be a Part of Your Fixed Income Portfolio?

The benefits of international investing expand beyond equity markets.  Including an allocation to international bonds provides positive diversification benefits and can improve the risk adjusted performance for a portfolio as well.

While the U.S. is a prominent portion of the global investment grade fixed income market place, it only represents roughly 30% of the total outstanding world debt.  Thus, 70% of the global bond market is unrepresented in a U.S. only bond portfolio.  Investing in a more globally diversified bond portfolio that provides exposure to market forces that expand beyond the U.S. market would require holding fixed income positions from issuers outside the U.S.  However, until the past decade investing in bonds outside of the U.S. has been limited by high costs and illiquidity.  More recently, increased globalization and a desire by governments to issue debt abroad has helped to ease the barriers to entry to this asset class.

In order to benefit a portfolio, the addition of international bonds would need to show low levels of correlation with U.S. fixed income.  This is certainly the case.  The U.S. has consistently shown to have low correlations with other countries with the large debt issuances over the 1999 to 2012 time period, ranging from 0.24 with Japan on the low side to 0.77 with Canada on the high side. 

While the low correlation is great, how has it helped in practice?  The benefits of the low correlation have been borne out historically.  When intermediate term U.S. government bonds, as represented by the Citi World Gov. Bond Index U.S. Component 1-10 years, have had a negative monthly performance, international intermediate government bonds, as represented by Citi World Gov. Bond Index ex U.S. 1-10 years, have shown slightly positive performance.  A portfolio of 75% U.S. bonds and 25% international bonds with currency risk hedged has had a lower standard deviation (3.71%) compared to a U.S. only bond portfolio (4.20%.)  This results in the more fully diversified portfolio having a higher Sharpe Ratio and, therefore, better risk adjusted performance.

Similar to equity markets, correlations in fixed income markets have risen over more recent time periods.  For example, the correlation between the U.S. and international bonds over the 1985 to 2012 time period was 0.63, while the correlation over the 1999 to 2010 time period was 0.69.  With the globalization of the world’s economies, a higher level of correlation than what long term historical averages suggest is likely.  However, each country has its own monetary policies and will likely find themselves in different stages of the business cycle creating imperfect correlations between countries that will continually fluctuate.

This diversification benefit can be removed if the global bonds held are not hedged for currency fluctuations.  The high volatility related to exchange rates eliminates the diversification benefit of holding international bonds.  The volatility of the Citi World Gov. Bond Index 1-30 year unhedged is 9.90%, which is over three times more volatile than the hedged version of the index.  This carries over to a simple diversified portfolio as well.  When adding unhedged international bonds to a portfolio that holds U.S. and International stocks and U.S. Bonds (represented by broad asset class benchmarks and their standard deviations over the past 25 years) it results in a more volatile portfolio.

Return Standard Deviation Chart World Ex US Bonds

One practical issue with hedging currency risk is the added cost.  If the costs are high they can undermine the benefits of the hedge and discourage investment in the asset class.  However, the cost of hedging has trended downwards over the past decade with costs a third lower than they once were.  The bid/ask spread between for contracts to hedge a foreign currency in U.S. dollars has dropped from approximately 0.24% in 2000 to 0.15% in 2011.With the increased technological efficiency of markets we expect this to continue.  At current levels the costs are not prohibitive and will not produce a significant drag on yield.

As it has been shown that adding an international bond allocation to a portfolio has been advantageous, what degree of allocation will allow a portfolio to fully realize the diversification benefit?  By performing an efficient frontier analysis and reviewing data over various time periods it is apparent that the ideal level of international fixed income is in the 20% to 40% range.  With an allocation below 20%, historically, a fixed income portfolio would not be benefiting fully from the diversification potential of the allocation, and with an allocation above 40%, foreign bonds have shown to deliver little additional benefit.  The best level will only be know in hindsight, but historically maintaining an allocation to currency hedged international bonds within that range has yielded the best risk adjusted performance.

Given international bonds increased diversification benefits and potentially higher levels of return; we believe including a dedicated allocation to the asset class and hedging for currency risk will improve an investor’s risk adjusted performance and help them achieve their long term investment goals.

 

 

Index Performance                                        May         YTD     Trailing 1 Yr       

US Stock (Russell 3000)                                   -6.18%        5.20%         -1.87%        
Foreign Stock (FTSE AW ex US)                    -11.27%      -2.54%       -20.25%        
Total US Bond Mkt. (BarCap Aggregate)          0.90%        2.33%         7.12%         
Short US Gov. Bonds (BarCap Gov 1-5 Yr)       0.17%       0.51%          2.26%       
Municipal Bonds (BarCap 1-10yr Muni)           0.43%        1.90%         6.39%        
Cash (ML 3Month T-Bill)                                   0.01%         0.03%        0.05%       

 

 

Disclosure:

Past performance is not a guarantee of future results and there is always a risk that an investor may lose money.  Information contained has been gathered from sources we believe to be reliable, but we do not guarantee the accuracy or completeness of such information. Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio.

All economic and performance information is historical and not indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this material, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from Raffa Wealth Management or any other investment professional.  Further, the charts and graphs contained herein should not serve as the sole determining factor for making investment decisions.  To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with Raffa Wealth Management.  All information, including that used to compile charts, is obtained from sources believed to be reliable, but Raffa Wealth Management does not guarantee its reliability.   All performance results have been compiled solely by Raffa Wealth Management, are unaudited, and have not been independently verified. Information pertaining to Raffa Wealth Management’ advisory operations, services, and fees is set forth in Raffa Wealth Management’ current disclosure statement, a copy of which is available from Raffa Wealth Management upon request.

There is no guarantee that any investment strategy, including those described here, will be successful. Any investment or investment strategy can lose money. Past performance does not guarantee or predict future results. You should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Raffa Wealth Management, LLC. This information was gathered from reliable sources but we cannot guarantee accuracy. Indexes do not reflect the fees associated with actual investments and such fees would reduce the performance illustrated.
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