Developed market bonds

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). 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. . 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).

Table 1. below, derived from data provided by Dimson, Marsh, and Staunton 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.

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.

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.

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.

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. . The table below shows the average of the nineteen country correlations over various time periods.

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."

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 failing on the cost issue. Should the cost of available international bond index funds (or ETFs) fall to 0.20% or lower, the asset class would pass Ferri's third requirement and merit consideration for strategic asset allocation in portfolios.

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.

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.

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 hedged international developed market index funds to their English, European, and Asian domiciled investors, but not to their U.S. domiciled investors. 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.)

A Vanguard press release announces that in early 2012 the firm will launch a hedged developed market bond index fund, the Vanguard Total International Bond Index Fund, based on the Barclays Global Aggregate ex-USD Float Adjusted Index (Hedged), which covers more than 7,000 bond issues. The fund will offer investor, admiral, and ETF shares. The estimated expense ratios and transaction fees for the fund are tabulated below.