What's the right allocation to international bonds?

May 23, 2013

 

Key highlights

  • Vanguard believes that a 20% allocation to international bonds represents a reasonable starting point for increasing diversification.
  • We do not recommend increasing global bond allocations if returns in the U.S. bond market turn negative.
  • Emerging market bonds have risk factors more highly correlated to equities and volatility closer to high-yield bonds.
 
Chris Philips

With the introduction of Vanguard Total International Bond Index Fund and Vanguard Emerging Markets Government Bond Index Fund, along with their corresponding ETF Shares, your clients may have questions about the global fixed income market. Vanguard Senior Investment Analyst Chris Philips answers some common questions facing advisors.

Why is now a good time for global fixed income?

International bonds are a major asset class, larger than international stocks, U.S. stocks, and U.S. bonds. At their root, highly graded bonds can be an effective diversification tool in reducing the risks of investing in global equity markets. U.S. investors have seen this relationship play out during the two bear markets and bouts of volatility since 2000. With international bonds, we would expect additional diversification because the return drivers for global bonds and U.S. bonds have not been highly correlated.*

So why now? The answer is simple: costs. The costs of investing in international bonds differ from those of investing in domestic bonds due to the role of hedging. The global bond market introduces added volatility caused by fluctuating exchange rates, and we believe this volatility should be mitigated through hedging. Historically, the costs of hedging, combined with the higher costs of investing outside the United States, created a high hurdle for obtaining the theoretical diversification benefits of foreign bonds. In the last few years, these costs have declined enough that we believe we can manage a fund conforming to the standards expected of Vanguard.

Why does Vanguard generally recommend that 20% of bond holdings be in the Total International Bond Index Fund or ETF?

There is no right or wrong allocation to foreign bonds. That said, we believe that 20% represents a reasonable starting point for investors interested in potentially increasing their diversification. Twenty percent strikes a balance between costs, the potential for diversification, the place of foreign bonds in the global market, and investors' home bias, which is the tendency to invest more heavily in domestic securities.

Why would investors want to invest in European and Japanese debt in today's environment?

Fixed income's role as a diversifier against riskier assets can have a significant effect on a portfolio. It's true that a lot has happened in the global markets in recent years—the Eurozone crisis, Japan's deflation, the downgrade of the U.S. credit rating. Yet investors who avoided global markets during this time didn't necessarily fare better than those who didn't. In fact, despite all the recent international turmoil and uncertainty, a portfolio that included exposure to both U.S. and foreign bonds (assuming the currency exposure was hedged) would have experienced a less volatile ride than a portfolio focused only on the United States.**

If returns in the U.S. bond market turn negative, should investors increase their global bond allocation?

Generally, we do not advocate taking a tactical approach. History and experience have shown that for those who engage in tactical strategies, the consequences of being wrong can be worse than the benefits of being right, and more often than not, investors would have been better off not making a change. For example, the fears of a so-called "bond bubble" have been in the media and on investors' minds for the last few years, and yet interest rates remain at very low levels while U.S. Treasury bonds continue to be the destination of choice for investors seeking a haven from global macro events.

While no one can predict the future, we believe that whether interest rates rise, fall, or remain at current levels, high-quality, diversified fixed income investments will continue to provide diversification to the riskier assets in a portfolio.

We also believe that both U.S. and foreign bonds can play a role in this objective.

In contrast, what's Vanguard's recommendation for an international equity allocation?

For international equities, we suggest starting at 30% of the total equity allocation. Considering again the trade-off of costs, diversification, and home bias, we are comfortable when investors deviate from that amount, even up to fully market proportional, which is currently about 50%.

What's the role of Vanguard Emerging Markets Government Bond Index Fund?

The emerging markets fund offers investors exposure to more risky credit-sensitive securities issued by emerging markets countries in U.S. dollars. Your clients should keep in mind that emerging markets bonds have risk factors more highly correlated to equities and volatility closer to high-yield bonds than traditional investment-grade bonds. In addition, because the fund invests in issues denominated in dollars, there will be overlap with the Total Bond Market Index Fund, which also invests in emerging markets bonds denominated in U.S. dollars.

Do the two new funds overlap?

No, there is no overlap of securities between the Total International Bond Index Fund and the Emerging Markets Government Bond Index Fund since the former will hold only investment-grade local-currency bonds and the latter will hold only U.S.-dollar-denominated bonds. So although both funds have exposure to emerging markets debt, they do so in different segments of the emerging markets universe. In the same vein, we don't consider the emerging markets fund to be a completion fund when added to the Total International Bond Index Fund since it represents exposure to only one portion of the emerging markets universe. That is, it will not hold corporate and securitized debt, nor will it hold local-currency debt.

* A study of various countries' levels of interest rates and inflation—the two most important drivers of bond returns—finds low and varied correlations with the U.S. levels from 1990 to 2011. These low and varied correlations are evidence of the potential diversification benefit of adding international bonds to a U.S.-only bond portfolio. Joseph H. Davis., Andrew J. Patterson, Christopher B. Philips, Charles J. Thomas, 2012. Global fixed income: Considerations for U.S. investors. Valley Forge, Pa.: The Vanguard Group.

** Data from January 1, 1985, to September 30, 2011, show that the volatility of two types of portfolios decreased when currency-hedged international bonds were added. Understanding the role of global bonds in client portfolios. Valley Forge, Pa.: The Vanguard Group

Notes:

  • All investing is subject to risk, including possible loss of principal. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Bonds of companies based in emerging markets are subject to national and regional political and economic risks. These risks are especially high in emerging markets.
  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • Total International Bond Index Fund is subject to currency hedging risk, which is the chance that currency hedging transactions may not perfectly offset the fund's foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. The fund will incur expenses to hedge its currency exposures.
  • Diversification does not ensure a profit or protect against a loss.
  • A registration statement relating to Vanguard Total International Bond Index Fund has been filed with the Securities and Exchange Commission but has not yet become effective. The fund may not be sold nor may offers to buy be accepted prior to the time the registration statement becomes effective. This communication shall not constitute an offer to sell or the solicitation of an offer to buy, nor shall there be any sale of, the fund in any state in which such offer, solicitation, or sale would be unlawful prior to registration or qualification under the securities laws of any such state.
  • For more information about Vanguard funds, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus. Investment objectives,risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. Copies of the final prospectus can be obtained from Vanguard. Please note that a preliminary prospectus is subject to change.
 

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