These are interesting times for international bond investors. On one hand, holders of Japanese and German long-term bonds have likely earned strong returns as concerns about global growth and central bank stimulus programs have pushed up bond prices. On the other, anyone looking to buy more foreign bonds must confront volatile currency markets, low interest rates and low or even negative yields—which could mean investors have to pay to hold some developed country foreign bonds.
One might ask: Why bother with foreign bonds at all? After all, the U.S. economy seems to be in better shape than many other economies, and yields on U.S. bonds may be low, but at least they’re not negative.
The simple answer is diversification. When you buy a foreign bond, you take on some exposure to a different economy and interest rates. And if a foreign bond is denominated in another currency, you stand to benefit if that currency rises against the dollar (though you also face the risk that a currency will weaken).
That’s why international bonds are one of the three building blocks of a diversified bond portfolio, the other two being core bonds and aggressive income assets (see section below). Schwab recommends that investors hold up to 15% of their fixed income allocation in international bonds, depending on their risk tolerance.
Here we’ll look at how international bonds differ from U.S. bonds and some of the risks and other considerations for including international bonds in your fixed income portfolio.
A tale of two bond types
The global bond market far surpasses the global stock market in terms of both size and complexity. This can pose a challenge to investors looking to build a globalized fixed income portfolio, so it makes sense to divide international bonds into two groups:
- Developed market bonds include government and investment-grade corporate bonds from more economically advanced countries, like Japan or the countries of Europe. The credit qualities for these bonds are usually similar to those of U.S. government and investment-grade corporate bonds.
- Emerging market bonds include securities from the developing world, such as China and other fast-growing economies in Asia as well as some South American countries. These types of bonds tend to be riskier than bonds from developed countries, which means that they may offer higher interest payments. But given their increased risk, most investors should consider limiting their exposure to them.
Foreign bond returns can be impacted by interest income, price changes and currency fluctuations. Interest income is always positive, and because bonds offer fixed coupons—barring a default, of course—this part of a bond’s total return is predictable.
Price and currency changes are less predictable and can vary depending on the market. Price changes depend on the direction of interest rates in the country where the bond is issued. Generally, when rates go up, bond prices fall, and vice versa. Currency swings affect the value of income payments and also amplify price changes, so they can have an outsized impact on returns (see chart below). For example, if you owned a euro-denominated bond, and the euro strengthened against the dollar, your returns from that bond would be higher in dollar terms. Of course, the opposite is also true, as a strong dollar erodes the value of returns in weaker currencies.
Because foreign bonds are subject to different economic growth, interest rate and currency market conditions, they tend to perform differently from U.S. bonds. Emerging market and developed market bonds have a negative or very weak positive correlation with U.S. Treasuries—meaning that the investments rarely move in tandem.
So what’s the outlook now? Sluggish growth in advanced economies, stubbornly low commodity prices and weak global trade are likely to continue to weigh on the global economy.
That could keep up the pressure on developed country central banks to continue stimulating their economies with low interest rates and bond-buying programs. European and Japanese central bankers have been buying government bonds and corporate bonds in a bid to pump more cash into their economies. That could keep prices high and yields low or even negative.
Emerging market bond yields are higher than developed country yields, both because the bonds are riskier and because emerging market currencies tend to be more volatile and can have a bigger impact on the total return of a bond investment. In addition, many emerging market countries rely heavily on exports, which could be a problem if global growth slows.
What to do now
Because of these challenges, investors who would like an allocation to foreign bonds in their fixed income portfolios could consider investing through a diversified bond fund or through an active professional manager.
For some investors, a combination of passive (indexing) and active strategies may make sense. An actively managed fund could provide access to a wider array of securities for greater diversification than an index fund. Also, actively managed funds can adjust their holdings in response to market conditions if necessary, unlike index funds (though actively managed funds tend to have higher fees, so that needs to be taken into consideration).
3 building blocks of your bond portfolio
- Core bonds: U.S. Treasury bonds, investment-grade corporate bonds and municipal bonds provide diversification, stability and income. They should make up between 65% and 100% of your fixed income allocation.
- Aggressive income: U.S. high-yield corporate bonds, emerging market bonds and preferred securities all offer higher income potential, but at significantly higher risk compared with core bonds. Even if you are an aggressive investor with a high tolerance for risk, aggressive income products should make up no more than 20% of your fixed income allocation.
- International bonds: Non-U.S. developed country bonds can provide diversification, but often carry higher risk. They can make up as much as 15% of your fixed income allocation.