International bonds make up the single largest component of this global value of U.S. and international stocks and bonds. At $26 trillion, international bonds comprise nearly a third of the total global value of stocks and bonds (about $79 trillion), according to research by Vanguard.
Diversification is the obvious argument to include the largest of all asset classes. Nearly all advisors include international equities in portfolio construction, so why would we exclude the even larger asset class of international bonds?
First, advisors must ask themselves and their clients what role they desire the bond portfolio to play. If the role is to serve as the portfolio’s shock absorber and provide some stability when stocks plunge, then there are a number of implications.
First, it eliminates international bonds in local currencies that are not hedged to the U.S. dollar. These funds typically act far more as a bet on a foreign currency than a bond, providing stability and income.
One must also eliminate non-investment grade international bonds, even if dollar denominated or hedged to the U.S. dollar, since junk doesn’t provide that stability.
Now what about high quality sovereign government debt as well as foreign investment grade credit? This might be especially relevant today given the political risk in the U.S., with the continuing threat of defaulting on debt by not raising the debt limit.
Typically, costs of high quality foreign bonds hedged to the U.S. dollar have been very high, but this changed last May when Vanguard launched its total international bond fund (BNDX). This ETF has an annual expense ratio of 0.20% plus estimated annual hedging costs of 0.05%. It is essentially the foreign equivalent of a bond fund that follows Barclays’ aggregate bond index such as the Vanguard Total Bond Fund (BND), with a 0.10% annual expense ratio.
It might seem like a no brainer to include this international bond fund, but as of Oct. 13, 2013, the 30-day SEC yield of 1.76% was a full 0.48% lower than the U.S. equivalent, while its 6.6 year duration was 1.1 years longer than the U.S. equivalent. This means a lower yield and more interest rate risk.
So at this point, the case for international bonds would be that it increases diversification but lowers expected return. A very close call.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct instructor at the University of Denver.