Investing in Foreign Bonds

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BruceM
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Investing in Foreign Bonds

Post by BruceM » Sun Jun 09, 2013 1:04 pm

Rick Ferri, Bill Bernstein and other CFAs offer their short-version views on investing in foreign debt.

http://www.oregonlive.com/finance/index ... cart_river

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am
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Re: Investing in Foreign Bonds

Post by am » Sun Jun 09, 2013 4:33 pm

So most think not necessary (int.bonds). Seems to me like at this time, it offers little diversification, little in the way of higher potential returns (except for EM bonds), and potentially higher risk where you do not want it.

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Re: Investing in Foreign Bonds

Post by nisiprius » Sun Jun 09, 2013 5:16 pm

According to Vanguard's own presentations:

1) In What's the right allocation to international bonds? Christopher Philips says
There is no right or wrong allocation to foreign bonds. That said, we believe that 20% represents a reasonable starting point for investors interested in potentially increasing their diversification."
Potentially increasing their diversification? :?

2) According to Global fixed income: Considerations for U.S. investors, a 20% allocation to currency-hedged high-quality foreign bonds would, historically, have decreased the standard deviation of the total portfolio

from 9.7 to 9.6.

That's if you had 30% international stocks. The international enthusiasts most likely to have an appetite for foreign bonds are probably holding more than that.

If you had globally cap-weighted international stocks, 55%, as in the Vanguard Total World Stock Index Fund, adding foreign bonds to a 60/40 portfolio would have "decreased" the standard deviation

from 9.8 to.... 9.8.

As a diversification story, that's not very compelling.

Image

(And for those who say they want the "currency diversification" of unhedged foreign bonds, for the 55%-international portfolio, adding 20% unhedged foreign bonds is shown as "reducing" the standard deviation

from 9.8 to 10.0).
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Re: Investing in Foreign Bonds

Post by bpp » Sun Jun 09, 2013 6:59 pm

nisiprius wrote: (And for those who say they want the "currency diversification" of unhedged foreign bonds, for the 55%-international portfolio, adding 20% unhedged foreign bonds is shown as "reducing" the standard deviation

from 9.8 to 10.0).
You're missing the point, at least partially. Currency diversification is not primarily about mean-variance optimization. It's a not-all-eggs-in-one-basket thing. The MVO output is only of interest to see how much extra volatility one incurs in the non-disastrous case, to make sure it is not too high to live with.

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Re: Investing in Foreign Bonds

Post by Beagler » Sun Jun 09, 2013 9:20 pm

Upon reading the comments, I'd gather than if Mr. Ferri or Dr. Bernstein were running the Vanguard Target Retirement Funds they would not have added in't bonds.
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Re: Investing in Foreign Bonds

Post by nedsaid » Sun Jun 09, 2013 9:33 pm

This is in the category of a subject that I have an opinion on, but that I realize there are good arguments for both sides. In other words, it is a hill that I am not going to die on.

Other items in this category are:
1) 3 fund portfolio vs slice and dice.
2) Foreign bonds vs No foreign bonds.
3) CD ladder vs bond funds.

I saw foreign bonds as another asset class to invest in. I saw the possible benefit of currency diversification (both of my funds are unhedged) as well as geographical diversification. There was no scientific process on my part, it looked like a good diversifier.

So look at the arguments on each side, do what is best for your situation. My feeling is that the diversification benefits of foreign bonds are limited compared to other asset classes. There is a case for owning these, it is not a pound the table and jump up and down case. As an investor, if you do the other things right you will do fine whether or not you own these.
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Re: Investing in Foreign Bonds

Post by Valuethinker » Mon Jun 10, 2013 3:56 am

nedsaid wrote:This is in the category of a subject that I have an opinion on, but that I realize there are good arguments for both sides. In other words, it is a hill that I am not going to die on.

Other items in this category are:
1) 3 fund portfolio vs slice and dice.
2) Foreign bonds vs No foreign bonds.
3) CD ladder vs bond funds.

I saw foreign bonds as another asset class to invest in. I saw the possible benefit of currency diversification (both of my funds are unhedged) as well as geographical diversification. There was no scientific process on my part, it looked like a good diversifier.

So look at the arguments on each side, do what is best for your situation. My feeling is that the diversification benefits of foreign bonds are limited compared to other asset classes. There is a case for owning these, it is not a pound the table and jump up and down case. As an investor, if you do the other things right you will do fine whether or not you own these.
Something of a guess, but you might find adding TIPS/ ibonds to a US Treasury bond portfolio adds *more* diversification benefit than currency hedged foreign bonds.

This is my issue with foreign bonds:

- the yield story is not compelling, for similarly rated investment grade countries, the bond yields have converged
- it does not appear to add a lot of diversification benefits

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Re: Investing in Foreign Bonds

Post by Valuethinker » Mon Jun 10, 2013 4:01 am

am wrote:So most think not necessary (int.bonds). Seems to me like at this time, it offers little diversification, little in the way of higher potential returns (except for EM bonds), and potentially higher risk where you do not want it.
Most of us have invested through an EM crash or two. Bonds in EMs have correlations with macroeconomic events which can be pretty unpleasant on the downside (lets see Mexico in 1981, Mexico in 1994, Thailand/ Indonesia etc. in 1997, Russia in 1998, Argentina in 2002...).

Now I accept that many EMs now appear to have 'Emerged' and in fact are better credit risks than the likes of Spain or Portugal, with the Eurozone crisis- thinking for example Mexico. Turkey right about now is showing us what EM risk is (at least on the equity side, haven't checked the bonds). You have nationwide rioting *and* you have a major civil war going on on its borders.

The spreads of EM bonds over developed country bonds are at record lows-- you are not being rewarded much for those risks, to my mind.

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Re: Investing in Foreign Bonds

Post by nisiprius » Mon Jun 10, 2013 5:52 am

nedsaid wrote:This is in the category of a subject that I have an opinion on, but that I realize there are good arguments for both sides. In other words, it is a hill that I am not going to die on.

Other items in this category are:
1) 3 fund portfolio vs slice and dice.
2) Foreign bonds vs No foreign bonds.
3) CD ladder vs bond funds.

I saw foreign bonds as another asset class to invest in. I saw the possible benefit of currency diversification (both of my funds are unhedged) as well as geographical diversification. There was no scientific process on my part, it looked like a good diversifier.

So look at the arguments on each side, do what is best for your situation. My feeling is that the diversification benefits of foreign bonds are limited compared to other asset classes. There is a case for owning these, it is not a pound the table and jump up and down case. As an investor, if you do the other things right you will do fine whether or not you own these.
+1

To add to this: I believe the urge to optimize is actually destructive. It's more important to understand that you really are taking a calculated risk. Risk means you really don't know what will happen. Optimizing means you are constantly convincing yourself that you do know what will happen, with such precision that you can actually tell whether foreign bonds are going to help you--in your portfolio--over your investing future.

Suboptimal investing isn't dangerous. Kidding yourself is dangerous.

I really believe that it makes a difference whether you are looking at new investments or established investments, and that established investors really should dig in their heels and resist fiddling, tweaking, and adjusting. That means that I am not planning to exchange any of my Vanguard Total Bond for Vanguard Total International Bond. However, if I happened to be holding a Target Retirement I would not drop it (or exchange it for an international-bond-free three-fund equivalent).

"I don't know for sure which is better, so I'll stick with whatever it is that I have."
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Re: Investing in Foreign Bonds

Post by bpp » Mon Jun 10, 2013 10:37 pm

nedsaid wrote: I saw foreign bonds as another asset class to invest in. I saw the possible benefit of currency diversification (both of my funds are unhedged) as well as geographical diversification. There was no scientific process on my part, it looked like a good diversifier.

So look at the arguments on each side, do what is best for your situation. My feeling is that the diversification benefits of foreign bonds are limited compared to other asset classes. There is a case for owning these, it is not a pound the table and jump up and down case. As an investor, if you do the other things right you will do fine whether or not you own these.
Pretty much my reasoning, and the reason I have included unhedged foreign bonds in my portfolio for the past 12-13 years.

I did actually try to apply a bit of analysis to the subject, first looking at historical back tests for a Japan-based investor, and later with a purely theoretical, simple mathematical volatility model. In the former case, there was a slight volatility reduction, in the latter a slight volatility increase, but the effect was really not very strong either way. So purely on the numbers, there does not seem to be a compelling case either way. In the end, I voted in favor of diversification just on general principle, but don't expect that it will make much of a difference in most possible future timelines.

I would be suspicious of impassioned arguments either for or against this asset class.

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Re: Investing in Foreign Bonds

Post by Valuethinker » Tue Jun 11, 2013 4:52 am

bpp wrote:
nedsaid wrote: I saw foreign bonds as another asset class to invest in. I saw the possible benefit of currency diversification (both of my funds are unhedged) as well as geographical diversification. There was no scientific process on my part, it looked like a good diversifier.

So look at the arguments on each side, do what is best for your situation. My feeling is that the diversification benefits of foreign bonds are limited compared to other asset classes. There is a case for owning these, it is not a pound the table and jump up and down case. As an investor, if you do the other things right you will do fine whether or not you own these.
Pretty much my reasoning, and the reason I have included unhedged foreign bonds in my portfolio for the past 12-13 years.

I did actually try to apply a bit of analysis to the subject, first looking at historical back tests for a Japan-based investor, and later with a purely theoretical, simple mathematical volatility model. In the former case, there was a slight volatility reduction, in the latter a slight volatility increase, but the effect was really not very strong either way. So purely on the numbers, there does not seem to be a compelling case either way. In the end, I voted in favor of diversification just on general principle, but don't expect that it will make much of a difference in most possible future timelines.

I would be suspicious of impassioned arguments either for or against this asset class.
If you are in Japan the case for international diversification is far greater. The stock market is not a huge percentage of the world stock markets. The bond market is huge and, arguably, somewhat rigged (functions as a savings account for domestic investors-- similar to Italy). And the bond yields are so low that the opportunity cost (ex currency) is relatively small.

The recent policy actions only muddy the picture, but the volatility is such that I think a prudent Japanese investor (planning to retire in Japan) is 50% out of Japan (probably at least).

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Re: Investing in Foreign Bonds

Post by bpp » Tue Jun 11, 2013 10:36 pm

Thanks for that, VT. Ok, so while the Boglehead principles are supposed to be universal (keep costs low and diversify), some of the recommendations made around here would seem to have to depend on where one is located. In particular, domestic/foreign weights of stocks and bonds, and whether to hedge or not.

I wonder if we can get some opinions from some of the experts on how their recommendations would change if they were advising residents of countries other than the US on their asset allocations? Rick Ferri and Bill Bernstein have been mentioned at the top of this thread, so could we possibly prevail upon at least those two to weigh in? (Ideally, I'd love to hear from Larry Swedroe and Jack Bogle as well!)

Perhaps even more useful than just percentage recommendations would be some indication of the reasoning behind the recommendations.

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Re: Investing in Foreign Bonds

Post by Valuethinker » Wed Jun 12, 2013 1:40 am

bpp wrote:Thanks for that, VT. Ok, so while the Boglehead principles are supposed to be universal (keep costs low and diversify), some of the recommendations made around here would seem to have to depend on where one is located. In particular, domestic/foreign weights of stocks and bonds, and whether to hedge or not.

I wonder if we can get some opinions from some of the experts on how their recommendations would change if they were advising residents of countries other than the US on their asset allocations? Rick Ferri and Bill Bernstein have been mentioned at the top of this thread, so could we possibly prevail upon at least those two to weigh in? (Ideally, I'd love to hear from Larry Swedroe and Jack Bogle as well!)

Perhaps even more useful than just percentage recommendations would be some indication of the reasoning behind the recommendations.
I would add a very non efficient markets view 'don't buy into something that looks terminally overvalued'. Dot com stocks in 2000. Japan in 1990. And probably JGBs now. If there were *inflation linked* JGBs now, then, fine, but AFAIK there are not. So you are getting paid 1% or lower yield. Lots of reasons why the Yen might still go up, so one could hold shortish term JGBs (up to 10 years). But the 30 year JGB?

(I realize that hedge funds have been ruined on that 'inevitable' trade which never happens-- ie short the JGB market).

I *still* have some reservations about the Japanese market, in that I think it's still possible to have the phenomenon we had in the 80s and early 90s, where a stock went up because Nomura said it would-- ie herd instinct of Japanese investors (retail and institutional). This is how the Saudi market works (closed to foreigners, since gambling is illegal (except betting on camel races and horse races?) they gamlbe on the stock market)-- incredible volatility. I definitely have reservations about Japanese corporate governance (they do not run their companies for shareholder value-- think Olympus, or Sony's struggles). that said there are many very cheap stocks in Japan (less so now than 6 months ago ;-)).

There is that book by the Financial Engines guy, that tries to index to the world market as investors do do their asset allocation (all assets).

In the absence of good data for a Japanese person, I would say:

- you want to be 50%+ in foreign assets, up to 70-80%. Japan is not a big stock market, and for all the reasons I have advanced it is not a *representatitive* bond market

- there are all dimensions of this. For example DFA does a global REIT fund which is 66% US, about 7% J-REITS I believe. that's the sort of weighting you want in that asset class if you choose to have it (ie reflective of the global weightings of different markets).

In practice a 50/ 50 investor who is 30% foreign bonds 20% Japanese, 30% foreign stocks, 20% Japanese is probably not doing too much harm to himself (pace taxes-- a black box to me). Lots of case for making those 40% and 10%-- that would be close to world averages, eliminating 'home country bias'.

I don't know what the gurus would say about this, Larry Swedroe would presumably know what the published literature says.

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Re: Investing in Foreign Bonds

Post by bpp » Wed Jun 12, 2013 5:58 pm

Valuethinker wrote: In practice a 50/ 50 investor who is 30% foreign bonds 20% Japanese, 30% foreign stocks, 20% Japanese is probably not doing too much harm to himself (pace taxes-- a black box to me). Lots of case for making those 40% and 10%-- that would be close to world averages, eliminating 'home country bias'.
Thank you, VT. I am at 50/50 Japan/foreign for both stocks and bonds, which I guess is not TOO far off from your recommendation. I don't go below 50% in Japan, partly because of currency arguments in favor of home bias made to me once by Norbert Schlenker (of Canada, which has an even smaller market size than Japan). I also figure, at 50/50, I'm indifferent to whether the yen rises or falls, to first order. (Yes, that ignores some pretty significant second-order effects, but trying to consider those starts to feel like getting into too-clever-by-half territory to me.)

What would you recommend for a UK investor, by the way? The stock market is about the same size as Japan's, I guess, right? Though you do have inflation-linked gilts available to individuals, which should lessen the need for foreign bonds, I imagine?
I don't know what the gurus would say about this, Larry Swedroe would presumably know what the published literature says.
Still hoping some of the other gurus will also weigh in. Rick? Bill? Larry? Dare I hope, Jack?

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Re: Investing in Foreign Bonds

Post by nedsaid » Wed Jun 12, 2013 11:04 pm

Thanks Nisiprius for your thoughts.

Yes, I am taking a small calculated risk. I can't quantify it. Who knows if I am optimising my portfolio or not? So I took a risk on the margins, so if I am wrong it won't be by much.

Really this decision came from a conviction that I wanted some diversification from the US Dollar. International Stocks and International Bonds give me that. The problem with the International Bonds is that since expected returns are lower than for stocks, the potential reward for the risk taken is less. A good case could be made that the reward isn't worth the risks taken. A conviction is not quantifiable.

Academic research has stated a strong case of the diversification benefits of International Stocks and how adding them can lessen the volatility and increase return of a portfolio when blended in with US Stocks. The case for adding International Bonds is much weaker. It is interesting that Vanguard decided there was enough benefit to add them to their target date funds. Vanguard might be wrong.

Thanks Valuethinker for your thoughts as well. Yes, I have TIPs funds in my bond portfolio. Have had them for years.

So it is a matter of preference. Will I be right? Not sure. Time will tell.
A fool and his money are good for business.

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