Developed market bonds

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Fig. 1. Global Bond Market

From the perspective of a U.S. domiciled investor, the international bond market makes up somewhat more than 35% of the market value of world investment markets (2011). [1] The global market is commonly divided into developed market bonds and emerging market bonds (see Fig. 1, Global Bond Market, for the country distribution by market value of developed market bonds in the Barclay's Capital Global Aggregate Bond Index). In many instances, countries issue both nominal and inflation indexed debt securities. Sovereign debt (issued by governments) is the prevalent asset comprising the international debt markets. Approximately 20% of market index composition is corporate debt as foreign companies primarily use banks, not capital markets, for debt funding. [2]. A key investment decision regarding international bonds is whether or not to hedge currency risk.

Risk and return

Like bonds issued in the U.S., international bonds pay interest according to set schedules and return principal at maturity. In addition to risks common to all bonds (Bond basics - Risks), international bonds bear currency risk unless this risk is hedged and political risk (for example, wars, revolution, sovereign debt defaults). [3]

Table 1. below, derived from data provided by Dimson, Marsh, and Staunton [4] in the Credit Suisse Global Investment Returns Yearbook 2011, provides real return,nominal return, and standard deviation of sovereign (treasury) bond returns for 19 countries from 1900-2000.

Table 1. Global Sovereign Bond Returns 1900-2010 (in US dollars) [5]
Country Real return Nominal return Standard deviation
Australia 1.40% 5.40% 13.20%
Belgium -0.10% 5.20% 12.00%
Canada 2.10% 5.20% 10.40%
Denmark 3.00% 7.10% 11.70%
Finland -0.20% 7.10% 13.70%
France -0.10% 7.10% 13.00%
Germany -1.90% 2.80% 15.50%
Ireland -0.90% 5.20% 14.90%
Italy -1.70% 6.80% 14.10%
Japan -1.10% 5.80% 13.90%
Netherlands 1.40% 4.40% 9.40%
New Zealand 2.00% 5.80% 9.00%
Norway 1.70% 5.50% 12.20%
South Africa 1.80% 6.80% 10.40%
Spain 1.30% 7.20% 11.80%
Sweden 2.40% 6.14% 12.40%
Switzerland 2.10% 4.50% 9.30%
United Kingdom 1.40% 5.40% 13.70%
United States 1.80% 4.80% 10.20%
World ex-US 1.20% 4.20% 14.20%
Globally diversified 1.60% 4.70% 10.40%

These long term return rates smooth considerable periods of both good and bad performance of global bond markets. Dimson, Marsh, and Staunton provide returns data for extreme real returns throughout the 1900-2010 history. The episodes include world wars; deflation; inflation and hyperinflation; beating inflation; and a golden era. Table 2. below provides the returns data for these episodes. One should note that the global bond returns during the world wars include the returns of the losers (Germany in World War I (-75%) and Japan (-99%) in World War II) and that hyperinflation epoch returns are real returns of individual national markets.

Table 2. Extreme Global Sovereign real returns 1900-2010 (in US dollars) [6]
Scenario Dates Cumulative return Annualized return
World Wars 1914-1918 -39.00% -
1939-1948 -49.00% -
Deflation 1923-1933 144.00% 11.80%
Hyperinflation
Germany 1922-1923 -100.00% -
Italy 1943-1947 -95.00% -
France 1945-1948 -84.00% -
United Kingdom 1972-1974 -50.00% -
Beating Inflation 1982-1986 94.00% 14.20%
Golden Era 1982-2008 649.00% 7.70%

Dimson, Marsh, and Staunton also examine real return drawdowns in the U.S and U.K. sovereign bond markets. Drawdowns are based by assuming an investor has the misfortune of buying bonds at their highest price level and computing the maximum cumulative decline at future dates. The recovery time to original levels is also computed (this includes reinvesting interest). The authors stress that the drawdowns are lower and recovery times sooner for nominal returns (which highlights the pernicious effects of inflation on nominal bond returns). Real return drawdowns are also lower, and recovery times faster, for balanced portfolios. The authors base this conclusion by assuming a 50/50 balanced portfolio of global stocks/global bonds.

Table 3. Real return drawdowns for U.S and U.K. Sovereign bonds (1900-2010) [7]
United States Date Loss United Kingdom Date Loss
Peak August 1915 Peak January 1935
Nadir June 1920 -51.00% Nadir September 1939 -33.00%
Recovery August 1927 Recovery April 1946
Peak December 1940 Peak October 1946
Nadir September 1981 -67.00% Nadir December 1974 -73.00%
Recovery September 1991 Recovery December 1993

Correlation

Developed market bond returns do not correlate precisely with U.S stock and bond markets. A Vanguard Institutional white paper, Global fixed income: Considerations for U.S. investors finds that, for the period 1990-2010, the correlations between U.S and international bonds for changes in long term bond yields and for changes in inflation, the two main drivers of bond returns, are low and varied. The correlation coefficients for changes in long term interest rates range from +.20 to +.65. The correlation coefficients for changes in inflation range from +.10 to +.50 .[8]

Dimson, Marsh, and Staunton report that the rolling 60 month average correlations between global stocks and global bonds (19 countries) for the period 1994-2010 ranged from -.38 to +.45. In addition, they also report monthly stock/bond correlations for individual national markets. [9]. The table below shows the average of the nineteen country correlations over various time periods.

Table 4. Average Stock-Bond Correlations
Date range Correlation
1900-2010 0.24
1950-2010 0.19
Monthly 2006-2010 -0.19

Pros and cons of international bond investing

In this section, we draw heavily on a 2011 paper entitled Global fixed income: Considerations for U.S. investors, in which Vanguard authors Christopher B. Philips et al. make a measured case for currency-hedged international bond funds. In this paper, they state:
"To make the strategic decision to include international bonds in a diversified portfolio, an investor should weigh the trade-offs among several factors" which they list as
  • the potential to reduce portfolio volatility,
  • exposure to the largest global asset class,
  • the costs of implementation,
  • the investor’s own views on the future path of the U.S. dollar.

It is crucial to distinguish between hedged and unhedged foreign bond mutual funds, and to know which kind you are buying. Unfortunately, actively managed funds tend to leave the managers free to perform whatever tactical hedging maneuvers they think best, so these funds often do not clearly characterize themselves as one or the other. In these funds, the managers attempt to exploit currency risk by making advantageous use of currency movements.

A hedged fund reduces currency risk by buying forward currency futures contracts. Such a fund promises to give investors the benefit of reduced portfolio volatility by global diversification across different bond markets, and exposure to the largest global asset class. However, hedging increases implementation cost. And it reduces risk both ways; an investor who predicts future weakening of the dollar might hope to benefit from currency risk.

Arguments for holding only domestic bonds

David Swensen, the investment manager of the Yale Endowment Fund, in his book, Unconventional Success: A Fundamental Approach to Personal Investment, advises U.S. domiciled investors to avoid foreign bonds funds in their portfolios and stick with treasury bonds and treasury inflation indexed securities (TIPs). Swenson argues that, for U.S. investors, treasury bonds offer protection against financial crisis and deflation, and treasury inflation protected securities provide protection against inflation. In the case of foreign bonds, foreign currencies provide no expected return and unhedged bonds do not offer investors the same protection against financial crisis and deflation as do treasury bonds. In addition, foreign bonds held by a majority foreign clientele introduce political risk to the security (the foreign government's interests might not be aligned with a non-citizen investor's interests in crisis situations). In summary, Swensen states his position:

Foreign-currency-denominated bonds share domestic bond's burden of low expected returns without the benefit of domestic fixed income's special diversifying power. Fully hedged foreign bonds mimic U.S. bonds (with the disadvantage of added complexity and costs stemming from the hedging process). Unhedged foreign bonds supply investors with U.S. dollar bond exposure, plus (perhaps unwanted) foreign exchange exposure. Foreign-currency-denominated bonds play no role in well constructed investment portfolios. [10]

Author Rick Ferri posits three tests for including an asset class in a portfolio:

  1. Does an asset class provide exposure to a unique investment risk?
  2. Does the asset class provide a real return (higher than the inflation rate)?
  3. Is the asset class available in a broadly diversified, liquid, low-cost fund?

Ferri judges international bond funds as passing the first two requirements, but prior to 2013 as failing on the cost issue with expenses not being 0.20% or lower. In May of 2013, Vanguard released their Total International Bond Index fund. That fund's Admiral and ETF share-classes both have expense ratios of 0.20%, passing Ferri's third requirement and now apparently would merit consideration for strategic asset allocation in portfolios.[11]

Arguments for holding hedged international bond funds

In Global fixed income: Considerations for U.S. investors, Philips et. al. state in their summary that "For the average investor seeking to minimize volatility in a diversified portfolio, we find that allocating from 20% to 40% of the fixed income portion to international bonds can provide a reasonable balance between diversification and cost, assuming that the currency risk inherent to this asset class is hedged."

In The Only Guide You'll Ever Need for the Right Financial Plan, p. 51, Larry Swedroe et. al. state that "Unhedged foreign-currency exposure for fixed-income investments is not generally recommended."

Currency risk has no expected return. There is no evidence of persistent ability to generate profits from currency speculation. Investors should not use these instruments to make speculative bets on the direction of particular currencies against the dollar. Investors seeking the diversification benefits of foreign-currency exposure by investing in international equities that are unhedged for exchange-rate risk. On the fixed-income side, investors generally seek stability of the value of these assets, allowing them to take equity risks....

Arguments for holding unhedged international bond funds

Some Bogleheads forum posters hold foreign bond funds as a way of intentionally obtaining an exposure to currency risk, because they expect it to be favorable. In this case, "the investor's own view of the future path of the U. S. dollar" weigh in the balance. They might consider investing directly in foreign currency itself, but see bond funds as superior because of the intrinsic return of the bonds themselves.

Reasons for not seeing currency risk as a negative factor include these: a) for the foreseeable future, they expect it to be favorable, i.e. it is a safe bet that the dollar will not strengthen soon; b) in the long run, currency risk is zero-sum and should neither increase or decrease expected return; c) currency risk is uncorrelated with other asset price movements and may improve portfolio returns as a whole.

Swedroe et. all note, also, that "Some investors--such as those living part-time in a foreign country or planning to retire in a foreign country--may be sensitive to the prospect of a falling dollar. Such investors may benefit from hedging their dollar exposure as part of their fixed-income portfolio toward achieving this hedge."

Market index

The most recognized international developed market bond index is a subset of the Barclays Global Aggregate Index (also available in a float-adjusted version) which measures investment grade fixed-rate debt markets. The international developed market subset of the Global Aggregate Index consists of the following sub indexes:

  • Two major components
    • Pan-European Aggregate (EUR 300mn)
    • Asian-Pacific Aggregate Index (JPY 35bn).

The remainder of the index consists of Global Treasury(ex US treasuries), Eurodollar (USD 300mn), Euro-Yen (JPY 25bn), Canadian (USD 300mn equivalent) index-eligible securities not already in the two regional aggregate indices. [12]

Barclays Capital also provides a benchmark for global inflation indexed bonds, the Barclays Capital World Government Inflation-Linked Bond Index. The international subset of this index includes bonds from UK, Australia, Canada, Sweden, France, Italy, Japan, and Germany. [12]

Morgan Stanley, Citigroup, BofA Merrill Lynch, and Deutsche Bank also provide international developed market indexes.

Index funds

Indexed portfolios of international developed market bonds for U.S. domiciled investors are currently available from ETF providers iShares and State Street Global Advisors. The portfolios are unhedged. Vanguard offers U.S investors hedged international developed market index funds in the form of both an ETF and a mutual fund. The firm uses the fund in the four fund portfolios designed for its balanced Vanguard LifeStrategy funds and its balanced Vanguard target retirement funds. Dimensional Fund Advisors offer hedged short and intermediate term global bond funds, available to do-it-yourself investors in some employer provided plans (as well as a 529 plan made available by the state of West Virginia.)

Table 5. International Developed Market ETFs
ETF Ticker Tracking index Expense ratio Hedging
iShares S&P/Citigroup 1-3 Year International Treasury Bond Fund [13] ISHG S&P/Citigroup International Treasury Bond Index Ex-US 1-3 Year 0.35% Unhedged
SPDR Barclays Capital Short Term International Treasury Bond ETF [14] BWZ Barclays Capital 1-3 Year Global Treasury ex-US Capped Index 0.35% Unhedged
iShares S&P/Citigroup International Treasury Bond Fund [15] IGOV S&P/Citigroup International Treasury Bond Index Ex-US 0.35% Unhedged
SPDR Barclays Capital International Treasury Bond ETF [16] BWX Barclays Capital Global Treasury Ex-US Capped Index 0.50% Unhedged
iShares International Inflation-Linked Bond Fund [17] ITIP BofA Merrill Lynch Global ex-US Diversified Inflation-Linked Index 0.40% Unhedged
SPDR DB International Government Inflation-Protected Bond ETF [18] WIP DB Global Government ex-US Inflation-Linked Bond Capped Index 0.50% Unhedged
SPDR Barclays Capital International Corporate Bond ETF [19] IBND Barclays Capital Global Aggregate ex-USD >$1B: Corporate Bond Index 0.55% Unhedged
Vanguard Total International Bond ETF [20] BNDX Barclays Global Aggregate ex-USD Float Adjusted Index (Hedged) 0.20% Hedged
Vanguard Total International Bond Admiral shares [21] VTABX Barclays Global Aggregate ex-USD Float Adjusted Index (Hedged) 0.20% Hedged

See also

References

  1. Davis, Joseph H. Ph.D., Patterson, Andrew J.; Philips, Christopher B. CFA, and Thomas, Charles J., Global fixed income: Considerations for U.S. investors, Vanguard Research and Commentary, January 2011.
  2. Davis, Joseph H. Ph.D., Patterson, Andrew J.; Philips, Christopher B. CFA, and Thomas, Charles J., Global fixed income: Considerations for U.S. investors, Vanguard Research and Commentary, January 2011 p.12
  3. For an examination of historical sovereign default risk see Sovereign Defaults and Debt Restructurings:Historical Overview, Chapter 1, pp. 1-26. Recent default experience is examined in a Vanguard white paper What’s Next for the Eurozone?
  4. The yearbook is an extension of the authors' 2002 book, Elroy Dimson, Paul Marsh, & Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns, Princeton University Press, 2002.
  5. Dimson, Marsh, and Staunton,Credit Suisse Global Investment Returns Yearbook 2011,
  6. Dimson, Marsh, and Staunton,Credit Suisse Global Investment Returns Yearbook 2011, p. 10.
  7. Dimson, Marsh, and Staunton,Credit Suisse Global Investment Returns Yearbook 2011, p.7.
  8. The international markets included in the analysis are Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Spain, and the U. K.
  9. Dimson, Marsh, and Staunton, Credit Suisse Global Investment Returns Yearbook 2011, pp 8-9.
  10. David Swenson, Unconventional Success: A Fundamental Approach to Personal Investment, pp. 122-124.
  11. Why I Don't Buy Foreign Bond Funds, Forbes 5/26/2011
  12. 12.0 12.1 Barclays Capital Index Product Factsheets
  13. S&P/Citigroup 1-3 Year International Treasury Bond Fund
  14. SPDR Barclays Capital Short Term International Treasury Bond ETF
  15. iShares S&P/Citigroup International Treasury Bond Fund
  16. SPDR Barclays Capital International Treasury Bond ETF
  17. iShares International Inflation-Linked Bond Fund
  18. SPDR DB International Government Inflation-Protected Bond ETF
  19. SPDR Barclays Capital International Corporate Bond ETF
  20. Vanguard Total International Bond ETF
  21. Vanguard Total International Bond Admiral shares

External links

Bibliography