International bonds: the good and the bad

Thirteen years ago, non-U.S. bonds made up only about 19% of the global investable universe of stocks and bonds. By the end of 2011, they made up 37%. But many U.S. investors still shun the asset class.
“There is a tremendous opportunity set out there for investors to further diversify their current portfolio,” says Christopher B. Philips, senior investment analyst at Vanguard.
But bonds tend to be illiquid, yields are low everywhere “…and, of course, you’re taking on exchange-rate risk,” counters David Wyss, adjunct professor of economics at Brown University and a former chief economist at Standard & Poor’s. “If you’re a U.S.-based investor,” he adds, “I’m not sure that makes a lot of sense.”
One thing is certain, foreign governments are, in general, more creditworthy than they were during the Mexican peso crisis of 1994. “Ever since then, we’ve seen a lot more solid fiscal and financial policy in emerging market governments,” notes Philips.
But a corollary is that bonds issued by countries with strong balance sheets have lower yields. “German bonds yield even less than [U.S.] Treasuries,” observes Wyss, who suggests that global corporate bonds might be more attractive. “There are some strong companies overseas, and the yields are a bit better,” he says.
True to Vanguard’s roots in indexing, Philips argues that active managers produce lower returns in global bond investing when adjusted for the increased risk they incur. Yet Wyss contends that to improve returns and take advantage of yield spreads, you may have to resort to active management.
But even that has a downside: “Active managers tend to charge quite a bit of money,” says Wyss, “which in the current yield environment is pretty hard to make up.”
With low rates likely to persist, advisors will have to choose between a low return, currency-hedged, indexed global bond portfolio, or one that incurs greater risk and higher cost in pursuit of larger returns.