(November 14, 2013) — Allocations to international bonds are increasingly becoming a method of diversification for US investors—particularly to reduce risk within a total return strategy, according to a Vanguard report.
The report found this approach was particularly popular with total return investors, who enjoy reducing risk through exposure to assets that perform differently in variant markets.
However, international bonds—though largely beneficial—appealed less to US pension portfolios using liability-driven investing strategies.
“The differing and, at times, low correlations between international and US bonds mean that combining these asset classes historically has presented investors with the opportunity to build a lower-risk fixed income portfolio,” said Eric Klein, a senior investment consultant at Vanguard Institutional Advisory Services.
Such low correlations were based on comparisons of inflation and interest rates between the US and foreign regions, conducted in Vanguard’s March research paper on global fixed income.
According to a Bank of America Merrill Lynch analyst note earlier this month, US investors are returning to bonds with a preference for corporate debt. Vanguard’s report supported this view, but found it was only recently that US investors found international fixed income an attractive asset class.
“Traditionally, international bonds have represented a significant part of the global investable market, but have been difficult to access because of low levels of liquidity, high costs, and other challenges,” the report said.
According to Vanguard’s data, foreign bonds were the second-smallest asset classes in 2000—only 19% of the global investable market. Today, the asset class has nearly doubled in relative weight to approximately 35%.
Myriad factors have contributed to this expansion, Vanguard concluded, including a spurt in globalization, greater access to information, freer world credit markets, and extensive debt issuance outside the US.
Despite the overall attractiveness of international fixed income, Vanguard suggested investors are often choosing funds that to help hedge their currency risk.
“Currency fluctuations today account for about two-thirds of the total volatility in international bonds and can overwhelm the diversification benefits of this asset class,” Klein said.
“Skilled hedging techniques allow investors to greatly reduce the volatility created by currency movements and capture the risk-return profile and diversification benefits offered by the underlying bond asset class.”
Related content: Investors Drop to Lowest Bond Allocations Since 2006, PIMCO: Rising Bond Rates Will Help Long-Term Investors, The Great Bond Revolution?, and Diversification is Still Better for Long-Term Investors