The Risks and Rewards Of International Bonds

The global bond market is far larger and more liquid than the global stock market. Over the last 25 years, the bond market has, on average, been 79% larger than the stock market, according to learnbonds.com.

Bonds provide stability against the volatile nature of stocks. In a 60/40 portfolio, 60% is allocated in stocks while the other 40% goes to bonds. As an investor approaches retirement, their allocation to bonds increases, mainly, so there is capital for them to withdraw during retirement.

Foreign bonds can make up part of the bond allocation within a portfolio. Let’s see why someone might consider the risks and rewards of foreign bond funds as part of their investment.

Why International Bonds?

Where do foreign bonds fit into portfolio allocation? Foreign bonds provide another means of portfolio diversification. A well-diversified portfolio protects capital against drawdowns or, at least, outsized drawdowns.

Foreign bonds also give you exposure to other parts of the world. If you have bonds in European and Asian countries that are doing well while the U.S. economy is declining, your bonds will do well also although your U.S. bonds might not. In this case, being diversified outside of the U.S. limits the negative impact of your bond holdings from a U.S. decline.

Of course, there are risks when investing in foreign bonds. Bonds from developed countries such as the U.K., France, and Germany are generally safer than bonds from emerging markets such as Indonesia, Malaysia, and Kenya. For those reasons, bonds from developing countries should only make up a smaller portion of your foreign bond holdings, assuming you have any at all.

For rebalancing purposes, foreign bonds are part of your overall bond allocation. As your foreign bonds rise in value and surpass your bond allocation target, some of those bonds should be sold and the funds re-allocated to weaker areas of your portfolio. This is general portfolio rebalancing so that each area of your portfolio remains within its target allocation (i.e., 60/40).

How Do Foreign Bonds Work?

Foreign bonds denominated in the issuing country’s currency (i.e., U.K. bonds in British pounds) will have an inverse correlation with the dollar. That means if the country’s currency rises relative to the dollar, your bond will benefit. This correlation is a double-edged sword, though. If the dollar rises relative to the country’s currency, your bond will be at a disadvantage.

There are other factors that affect foreign bond prices:

• Direction of interest rates
• Inflation expectations
• Credit of the issuer
• Currency markets
• Economic growth
• Monetary and fiscal policies of the issuing country

How To Invest In International Bonds?

Rather than buying the bonds of some country directly, which can be complex, you can invest in foreign bonds through mutual funds and ETFs. These financial instruments will also be more diversified than a single bond. For this convenience, you’ll pay a management fee or expense ratio. Expense ratios have come down a lot in recent years. Finding a bond with a fee of less than 0.50% should not be difficult.

Plus, many places allow you to invest in bond funds and bond ETFs for free. Check out our list of free investing apps here.

As an example, go to the personal investor section Vanguard.com and then Vanguard ETFs and “browse Vanguard ETFs.” Here, you’ll find a section called “International bond ETFs,” which currently list three different types of international bond ETFs. Let’s look at two of them to understand what exactly they are invested in.

Total World Bond ETF (BNDW) — this ETF has an expense ratio of only 0.06%. What makes it international? If you navigate to the “Portfolio Management” tab for any of Vanguard’s investments, you’ll see what the investment is holding. BNDW is allocated to the following regions:

In that same section, you can see that the ETF does have some holdings in “non-U.S. dollar-denominated bonds.” Scrolling down a little more until you reach “Distribution by issuer,” you can see the sectors and types of investments this ETF is invested in. They include:

• Asset-Backed
• Commercial Mortgage-Backed
• Finance
• Foreign
• Government Mortgage-Backed
• Industrial
• Other
• Treasury/Agency
• Utilities

Next to that section is the credit rating distribution for the bonds held in the ETF. Below the above two sections is the “Market allocation.” Now we get into the various country bonds that make up this ETF.

If you are looking for a bond ETF that is mostly foreign holdings, this might not be what you want. Notice that 44.1% of the holdings are in the U.S. If you already have U.S. bond funds, you may decide to look at another product for better diversification into foreign bond markets.

Total International Bond ETF (BNDX) — using the same techniques from above to investigate, we can see that this ETF holds only a 3.4% allocation to the U.S., providing good exposure to foreign bond markets.

BNDX provides good foreign bond diversification for anyone who doesn’t already have investments in foreign bonds. The expense ratio is only 0.08%. As you look at bond fund offerings from different brokerages, you’ll see similar fees and information about each bond. Armed with this knowledge, you should feel more confident in your ability to find a foreign bond fund that suits your portfolio.

Final Thoughts

International bonds can provide a great diversification to your portfolio. Just like other investments, they do carry risks, but they also carry unique returns that could work well for your asset allocation needs.