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4 Questions to Ask Before Adding International Bonds to Your Portfolio

For a small category, the world-bond group features a confusing array of choices.

Christine Benz 15/09/14

Investors are giving their bond portfolios a foreign flavor, judging by Morningstar's recent fund flow data.

Traditional mutual funds in the world-bond group have garnered nearly $7 billion in new investor dollars over the past year, even as funds in the intermediate-term bond group have seen $37 billion flow out the door.

But even as investors have been attracted to the world-bond category, it's easily one of the trickiest to navigate. It's compact--with fewer than 100 distinct funds--but it's full of offerings with disparate strategies. Foreign-currency exposure is a key differentiator, but funds also vary in their approaches to market maturity, interest-rate risk, and sector choices (government-issued versus corporate-issued bonds), among other factors. And of course there are passively managed products--both index funds and ETFs--as well as active.

Each of those distinctions carries with it implications for funds' risk/reward profiles, so an international-bond offering that's right for a 40-something accumulator may not be right for a retiree who's simply seeking to add a bit of extra diversification to her fixed-income portfolio.

Before adding international-bond exposure, ask yourself the following investment portfolio management questions.

Question 1: What's my existing foreign-bond exposure? 
Before adding an international-bond exposure to your portfolio, it's worthwhile to check up on how much of a stake you already have. Your fund company's website should have the latest data on the percentage of your bond funds' portfolios that are devoted to foreign bonds; it may also include some discussion of the complexion of those holdings (for example, whether those bonds are denominated in foreign currencies) and country weightings.

Question 2: What am I hoping to achieve by adding foreign bonds? 
One simple rule of investment portfolio management, any time you're adding an investment, it pays to step back and consider what goals you're trying to accomplish with the addition.

Are you adding a world-bond fund to serve as an aggressive kicker to an otherwise staid fixed-income portfolio, as would be the case with a high-yield bond fund? Are you comfortable with a volatility level that falls somewhere between that of a stock fund and a high-quality U.S.-bond fund? If so, it's fine to focus your energies on more aggressively positioned world-bond funds, many of which hedge their foreign-currency exposure and delve heavily into emerging-markets bonds. The free-ranging Templeton Global Bond is a prime (and Gold-rated) example of this subtype: Manager Michael Hasenstab eschews the developed-markets bonds that populate many world-bond funds' portfolios, focusing instead on emerging-markets bonds issued by countries where he thinks the fiscal picture is improving. Returns have been exceptional, but note that they'll tend to be much more highly correlated with stocks.

Alternatively, perhaps you're considering a world-bond fund to globally diversify your bond portfolio across interest-rate and inflationary environments, but you're not looking for a big pickup in returns relative to what you're already getting from your high-quality fixed-income holdings. In that case, a milder-mannered offering--one that hedges its foreign-currency exposure back into the dollar and focuses largely on developed markets--would better help you achieve your goals.

Question 3: Do I fully understand the strategy and its implications? 
Once you've homed in on what subtype of world-bond fund you'd like to investigate further, the next step is to make sure you fully understand the strategy and its implications for your investment portfolio management. Here are the key factors to assess.

Hedging foreign bonds: This tends to be one of the biggest differentiators for world-bond portfolios, and in turn their risk/reward profiles. Funds that invest in nondollar-denominated securities will tend to provide better diversification for a U.S.-bond portfolio than those that use hedging foreign bonds strategies to wash out the foreign-currency effects. The downside of funds that employ unhedged strategies, however, is that they tend to have much higher volatility than those that hedge. PIMCO's hedged and unhedged foreign-bond funds provide a great illustration. The hedged version, PIMCO Foreign Bond (USD-Hedged) has a standard deviation that's just a touch higher than the Barclays U.S. Aggregate Bond Index, whereas its unhedged sibling, PIMCO Foreign Bond (Unhedged), has experienced more than twice as much volatility, as measured by standard deviation. Note that hedging foreign bonds policy isn't always an either/or decision; some funds employ hedging on a tactical basis. 

Market Maturity: Most world-bond funds give themselves the leeway to invest in bonds from emerging markets as well as developed, but they vary widely in their implementation. Not surprisingly, funds with higher emerging-markets weightings have better long-term returns than those with lower weightings, but their volatility levels are also higher.

Sector Breakdown: While hedging foreign bonds policy and market maturity will tend to be the biggest determinants of world-bond funds' risk/reward profiles, funds also vary in their sector weightings. Some funds stick exclusively with government-issued bonds, while others will venture into corporates. Note that a focus on government bonds doesn't automatically make a fund's strategy conservative; for example, Templeton Global Bond has a heavy emphasis on government-issued emerging-markets bonds, and it has tended to have high volatility relative to its peers.

Question 4: What's an appropriate allocation? 
In investment portfolio management, once you've found the right fund and researched its strategy, the next step is to consider how much of your portfolio to put behind it. The answer depends on the type of fund you've chosen.

If you've opted for a more aggressively positioned fund, especially one that does not hedge its foreign-currency exposure, it makes sense to keep your position to a fairly modest size--perhaps 10% or even less of your total fixed-income portfolio. You'll also want to consider reducing the size of your position in the aggressive world-bond fund--or even eliminating it altogether--as retirement draws near. The reason is that unless you intend to spend your portfolio in a currency other than the dollar, the foreign-currency fluctuations that accompany an unhedged bond portfolio are a wild card that most retirees don't need. 

However, if you've opted for a mild-mannered, hedged world-bond fund focused on developed markets, you could arguably maintain a substantially higher weighting, not only during your accumulation years but during retirement as well. The key reason is that such a portfolio will tend to exhibit a risk/reward profile much like high-quality U.S. bonds, while also providing at least some extra diversification. In a research paper, Vanguard concluded that allocating 20% to 40% of a fixed-income portfolio to hedged international bonds can help investors pick up extra diversification without substantially increasing their total portfolio costs.

About Author Christine Benz

Christine Benz  

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.