New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 9,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

International Bond ETFs and Funds: Should You Own Them?

Most discussions of asset allocation suggest that you keep a portion of your stock holdings in international funds as opposed to U.S. funds. What you don’t hear very often is the suggestion to include international bonds.

But would it be a good idea to do so?

It depends on your circumstances, but in most cases, I’d say no. International bonds aren’t worth owning due to:

  • Higher expenses, and
  • Currency risk.

Higher Expense Ratios

You can easily find U.S. bond ETFs and funds with expense ratios of 0.15% or less per year. And (depending on your brokerage firm) you won’t even have to pay a commission to buy them.

In contrast, for international bond ETFs, expense ratios in the range of 0.35-0.50% are typical. And in most cases, you’ll have to pay commissions on each transaction.

Or, if you don’t want to pay commissions for your international bond holdings, you can go with an open-end mutual fund. As far as I can tell though, there aren’t any open-end international bond funds with expense ratios of less than 0.80%. (If you know of one, please mention it in the comments.)

In other words, international bonds come at a cost of ~0.50% more than you would pay for a decent U.S. bond index fund.

In contrast, the difference in expense ratios between U.S. stock funds and international stock funds is much smaller: often less than 0.20%.

Takeaway: International diversification for your bonds is significantly more expensive than international diversification for your stocks.

Currency Risk

International bonds (and international stocks) carry currency risk. Currency risk is the risk that the currency in which the investment is denominated will decrease in value relative to the dollar, thereby decreasing the investment’s value.

Example: Imagine that you own Russian bonds with a 5% yield. Over the life of the bonds, if the Russian ruble decreases in value relative to the dollar at a rate of 3% per year, your return will only be (roughly) 2%. Of course, the opposite could happen too: the ruble could increase in value relative to the dollar, thereby increasing your returns.

But we don’t know which will happen. That’s why we call it currency risk.

Why Do You Own Bonds?

Whether or not it makes sense to pay higher expenses and take on currency risk depends on your goals.

For many U.S. investors, the purpose of owning bonds is to earn relatively predictable returns. If that’s why you own bonds, I’d stick with U.S. bonds (TIPS, in many cases). Because international bonds come with currency risk, their returns (as measured in U.S. dollars) are less predictable.

On the other hand, if you’re an “asset class junkie” whose goal is simply to add one more (hopefully) uncorrelated asset class to your portfolio, then an international bond fund may make sense. But even then, because of their high expense ratios and relatively low long-term expected returns, international bonds aren’t exactly optimal.

For the most part, the only scenario in which it makes a lot of sense to own bonds denominated in a foreign currency is when you have expenses denominated in that currency. For example, if you’re saving for a vacation villa in Spain, you may want to do so with Euro-denominated bonds.

New to Investing? See My Related Book:

Book6FrontCoverTiltedBlue

Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less

Topics Covered in the Book:
  • Asset Allocation: Why it's so important, and how to determine your own,
  • How to to pick winning mutual funds,
  • Roth IRA vs. traditional IRA vs. 401(k),
  • Click here to see the full list.

A Testimonial:

"A wonderful book that tells its readers, with simple logical explanations, our Boglehead Philosophy for successful investing." - Taylor Larimore, author of The Bogleheads' Guide to Investing

Comments

  1. Some currency risk is desirable during accumulation years, or whenever a portfolio contains significant volatility, because it affects returns in a new and non-correlated fashion, which would tend to smooth them. There are obviously some caveats there, but I just wanted to point it out in principle. Regardless, fixed income isn’t the best place to take on currency risk because it attacks the attribute that we all go to fixed-income for: more predictable returns with low downside risk. But some international bond funds (many?) are currency-hedged for this reason – you just have to shop for exactly what you want.

    It is a shame that expenses can be so much higher for those funds. I’d be interested in seeing some of the better options. Because there is a very real advantage to investing in the bonds of other nations: exposure to different (and often low-correlating) interest rate environments. Since interest rate movements are the biggest mover of bond prices, diversifying across multiple interest rate environments can reduce the already-low volatility of bonds even further. Another way of putting this is that interest risk is not entirely systemic – not if you look far enough away from home – and can therefore be diversified against.

  2. Hi Mike, Every so often I return to look at foreign bonds. In general, I prefer individual bonds to funds due to the principal risk. Whenever I go through the international bond analysis, the uncertainty of currency movements as well as the high expenses, I return to the more “conventional” asset allocations (of course, with a healthy international equity stake). Thought provoking.

  3. You make a great point regarding the expense ratios of international bond funds.

    Curious – if you have an expectation that that the dollar is going to go down in value due to excessive (at least in my mind) money printing does that change one looking at international/Emerging Market bond funds?

  4. Hi Jeff.

    If you’re confident that the US dollar will decrease in value relative to a specific other currency, yes, investments denominated in that other currency become relatively more attractive.

  5. @Jeff

    1. If using international bonds for that purpose, remember to read the fund documentation to make sure your fund isn’t engaging in currency hedging.

    2. Consider counter-arguments to your expectation very carefully:

    a. The position and policy of the US is not a secret – everyone else has exactly the same data you do. Worries about the dollar have already had an effect.

    b. Other nations are pretty adept at printing money too, and its only the difference between them that matters for your purposes.

    c. The problem with macroeconomics is that no one can do it. The effects of monetary policy can take years to be seen. We could have runaway inflation start three months from now, or three years from now, or never. As much as I hate what is being done by the Fed right now, I believe it is possible for the status quo to continue for quite sometime.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2013 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy