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Should You Add International Bonds to Your Portfolio?

In November of 2011, Vanguard announced plans to create two new bond index funds: a Total International Bond Index Fund and an Emerging Markets Government Bond Index Fund. Then, for whatever reason, things got put on hold.

Last week, however, Vanguard announced that their Total International Bond Index Fund is going to be open to investors sometime in the second quarter of this year.

In addition, they announced that the new fund will be added to all of their Target Retirement and LifeStrategy funds. (Specifically, 20% of the bond allocation of each fund-of-funds will go to the new international bond fund.)

Costs

For the new Total International Bond Index Fund, Vanguard anticipates a 0.20% expense ratio for Admiral shares and ETF shares and a 0.23% expense ratio for investor shares.

In other words, international diversification for your bonds will cost you approximately 0.10% per year (calculated as the new fund’s 0.20% expense ratio, minus the 0.10% expense ratio of the domestic Total Bond Market Index Fund). That’s roughly on par with the cost of international diversification for stocks (given a 0.12% difference in expense ratios between Vanguard’s Total International Stock Index Fund and Total Stock Market Index Fund).

Do International Bonds Improve a Portfolio?

The following is what I wrote when the funds were first announced. I think it’s still applicable.


My initial thought — and please note that this is just average-Joe commentary here, as I am not an economist — is that international bonds could offer a diversification benefit, with the simple reason that interest rates in the U.S. are largely affected by the actions of the Federal Reserve, whereas rates in other countries are going to be more heavily impacted by the actions of their own respective governments.

A 2011 research paper from Vanguard offers us some historical data that supports the idea that international bonds offer a bit of a diversification benefit.

The paper showed that the monthly returns of international bonds (as measured by the Barclays Capital Global Aggregate ex-USD Hedged Index) had a 60% correlation to the monthly returns of U.S. bonds (as measured by the Barclays Capital U.S. Aggregate Bond Index) from 1988-2010. That’s significant correlation, but it’s still low enough to suggest that international bonds could be helpful.

The paper also showed that from 1985-2010, for a 60% stock, 40% bond portfolio, as you move more of the bonds from domestic to international, the portfolio’s overall monthly volatility decreases very slightly.

While these two data points do give some indication that holding international bonds is likely helpful, they’re not exactly overwhelming. And as always when using historical data, we must remember that it’s just that — historical. We don’t know whether international bond diversification will be more helpful, less helpful, or even detrimental going forward.

Currency Hedging

One important point about the fund is that it will be currency-hedged. That is, the fund will use currency exchange contracts to reduce the volatility that would otherwise be caused as a result of the U.S. dollar fluctuating in value as compared to the various currencies in which the fund’s international bond holdings are denominated.

The result of this hedging is that currency risk for this fund should be minimal.

So Should You Buy The New Fund?

The flip side of the decision to currency-hedge the Total International Bond Index Fund is that its performance will be much more closely correlated to the performance of U.S. bond funds than would be the case if the fund were not currency-hedged. In other words, the decision of whether or not to include this fund in your portfolio will probably not be on the list of most important investing decisions you’ll ever make.

As a general rule, I think it’s wise to watch something for a few years — long enough to have a good handle on how it tends to behave — before putting a large portion of your portfolio into it.

Because my wife and I currently use the Vanguard LifeStrategy Growth fund (with its 80% stock, 20% bond allocation) for our retirement savings, that means 4% of our retirement portfolio (20% of the 20% bond allocation) will be put into this new fund. That’s a pretty modest allocation — not enough to cause me any worry whatsoever.

That said, if we instead used a DIY portfolio of individual index funds, I would probably be inclined to wait and watch the fund for some years before moving anything into it.

There’s no need to rush.

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Comments

  1. Nice post Mike.

    I am reading “Paper Promises” (http://amzn.to/VbhFDx), which includes a great history of international debt. I highly recommend it to anyone who is investing in this arena. It is by a veteran author of “The Economist” magazine.

    Can you please tell us the breakdown debt by country? Which countries are included in this fund, and what is the relative weighting by country?

    Thanks.

  2. Clark,

    Thanks for the book recommendation.

    The answer to your question is that we don’t know yet.

    The following comes from the announcement article:
    “As of December 31, 2012, the index’s top country holdings included Japan (23%), France (12%), Germany (11%), and the United Kingdom (9%). The index caps its exposure to any single bond issuer, including a government, at 20% to meet regulated investment company (RIC) tax diversification requirements.”

    But the fund’s preliminary prospectus filed with the SEC just has “xx.x%” in the tables where the asset allocation information would be found for a fund that’s currently open to investors.

  3. Hmm… I wonder if it would make any sense at all to slightly decrease one’s international equity holdings when adding international bonds? I would be worried about overexposure to currency risk, but then again, there’s that hedging you mentioned.

  4. Jeff,

    Given the hedging, I wouldn’t worry about currency risk any more than I do now (without international bonds).

    There’s a table that might interest you on page 11 of the research paper from Vanguard that I linked to above. It looks at the annualized standard deviation of monthly returns for a 60% stock, 40% bond portfolio with varying levels of international exposure both within stocks and within bonds.

    My conclusions from the results in the table would be that:
    1) 20-40% of stocks being devoted to international appears to be the “sweet spot,” regardless of how much is in international bonds, and
    2) The difference one way or the other is pretty slim until you get close to the extreme ends of the spectrum (i.e., all domestic or all international).

    But, as mentioned above, that’s just historical data. The future could certainly look different from the particular period covered by that table.

  5. Clark Kent says:

    Mike,

    Where can I find out additional information about the detailed holdings of this index?

    I clicked thru to the prospectus and see the “xx.xx%” info that you mentioned. I noticed that China is not mentioned there. Does China not sell bonds (or not sell them to foreigners)?

    Please explain.

    Thanks.

  6. Clark,

    Sorry to say, but I don’t have an explanation. Other funds (e.g., RMB) do hold Chinese bonds. Perhaps this fund will do so as well, but they’re currently left out of the example allocation in the prospectus.

    While it’s easy to find information about funds — regardless of the provider — because of Morningstar, there’s no such comparable service that provides information about indices themselves. So you’re left looking for it at the index provider’s website, which often leaves much to be desired.

    Barclay’s “Guides” page has a pdf about their Global Aggregate Index. Among other things, it mentions that they will create custom sub-indices for you. I suspect that the index that the new Vanguard fund will be tracking is just such a custom sub-index (leaving out US bonds, currency hedged, and limited to 20% of the portfolio being invested in any one issuer, and limited to 48% of the portfolio being invested in issuers that constitute 5% or more of the portfolio).

  7. Thanks for your analysis of the new fund. I also found a similar assessment here:

    http://investorplace.com/2013/02/vanguard-finally-charts-course-for-international-bonds/

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