Why Invest in International Bonds?
By Kathy A Jones
No matter what kind of bond you own, its price and yield are going to be influenced by a number of risk factors—the direction of interest rates, inflation expectations and the credit of the issuer being the most prominent among them. When you invest in international bonds, you add another level of risk stemming from currency markets, economic growth and monetary policy in the issuing country.
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. In addition, yields on U.S. bonds may be low, but at least they’re not negative, as has been the case in some developed markets in recent years.
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 “3 building blocks of your bond portfolio,” below). Schwab recommends that investors hold up to 10% of their overall portfolio 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 bondsinclude government and corporate bonds from more economically advanced countries, like Japan or the countries of Europe. While developed market bonds often have investment-grade credit ratings, the credit quality can vary.
Emerging market bondsinclude securities from the developing world, such as China and other fast-growing economies in Asia, as well as some South American countries. These 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 usually 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 interest payments and also amplify price changes, so they can have an outsized impact on returns (see “Components of return,” 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.
Components of return
Currency returns can have a big impact on international bond returns.
*As of 05/31/2019.
Source: Schwab Center for Financial Research using Bloomberg Barclays Global Aggregate ex-USD Total Return Index. Past performance is no guarantee of future results.
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.
How to invest
Investors who are seeking 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 can help provide diversification, stability and income. Although allocations can vary, they can comprise up to 100% of your overall portfolio 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 overall portfolio allocation.
International developed bonds:Non-U.S. developed country bonds can provide diversification, but often carry higher risk. They can make up as much as 10% of your overall portfolio allocation.