Foreign bonds: Do you need them?

by Pop on July 10, 2010

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Just because you can doesn’t mean you should.

A decade ago, there were few options for investing in foreign bonds that didn’t cost a bundle. Even today, you’re going to have a lot of trouble investing in foreign bonds directly. But the options for investing through mutual funds and ETFs, either with active or passive managers, have truly proliferated, which might make you wonder whether it’s worth adding a fund and how much to stick in it.

It’s easy to see the attraction. Ten-year U.S. Treasury bonds only yield 3.05% right now. Put that in contrast to bonds from Australia, which yield 5.11%, or—steppin’ on down the development ladder—Brazil, which yield 12.28%. Holy cow. Brazil is still a developing and sometimes unstable country, but 12.28% is better than you’d get from a company like Ford, which has an issuance maturing in 2018 that yields 6.5%.

Yield aside, the real question is this: Should passive investors have them as a standard part of their allocations?

First obstacle: You might not have the option.

This is an unfortunate side effect of the most common vehicle we use for retirement savings—the 401k. Many (probably most) 401k plans don’t have a foreign bond fund as an option to invest in. This might be a good thing, given that a lot of investors, who don’t know what they’re doing, could do something silly like equally weight all the options available to them, thereby putting a huge amount in a foreign bond fund.

That said, in a traditional account or an IRA, you most certainly do have the option to invest in foreign bonds through ETFs or funds. Two of the more popular actively managed funds are PIMCO Foreign Bond and T. Rowe Price International Bond. Their expense ratios aren’t great, but they are under 1%.

And although your anti-active manager neurons are surely firing right now, remember that the argument for a market-capitalization weighted index fund for bonds is a bit weaker than for stocks. For stocks, investing in the biggest companies might make sense. But for bonds, it would essentially mean you’d invest the most in the countries with the most debt. Does that make sense to you?

Second obstacle: These don’t add stability to your portfolio.

It’s probably tempting to carve out 5% to 10% of your bond portfolio for foreign bonds in the same way that you might do it for foreign stocks. But remember why you have bonds in your portfolio in the first place: To lessen volatility as you grow older.

Most foreign bond funds don’t do that. Why? Unless they say otherwise, the funds aren’t currency hedged, meaning that their shifts in price come not only from changing yields, but from how, say, the New Zealand kiwi fares against the U.S. dollar. And currencies can be extremely volatile.

Take the PIMCO Foreign Bond fund mentioned above. According to CBS Moneywatch, it’s three times more volatile than the Vanguard Total Bond Market Index, which only invests in U.S. bonds.

You might think holding foreign currencies is a good thing. We all know that the federal government will eventually have to pay its debts somehow. Since politicians are loathe to raise taxes or cut spending and the economy is slow, the dollar will probably have to be devalued.

But that’s not a sure bet. Japan, for example, is the banner example of a country that’s in debt up to its eyeballs. Yet its currency has held steady for 10 years, and the country is actually experiencing deflation. What’s more, bonds are about stabilizing your portfolio, right? Not making a bet on currencies one way or the other. And ultimately, you’re going to be spending your retirement savings in U.S. dollars.

So who are they right for?

I won’t say “no one.” After all, some really smart bond investors, like Bill Gross, have recently come out in favor of foreign bonds from countries much less indebted than the U.S. But in the end, I think they’re probably unnecessary for most people.

Why? Well, the mission for your bonds is fundamentally different than that of people like Bill Gross. He wants to beat the market. You just want to add some stability to your portfolio. Since foreign bonds don’t fit that bill, they’re more akin to a replacement for alternative asset classes like real estate investment trusts or even for stocks. And since there are much more clear cut (not to mention cheaper) ways to get exposure to those assets, personally, I’d rather stick with what I know.


{ 1 comment… read it below or add one }

Rob Bennett July 10, 2010 at 11:33 am

I’d rather stick with what I know.

I agree completely, Pop.

I have not been invested in U.S. equities going back to the Summer of 1996 because of the out-of-control valuations. People will sometimes ask me why I don’t invest in Japanese equities since they had their crash a ways back. My response is that that might be a good idea and that might not be a good idea. I would need to study the Japan market for a long time to know and I just don’t have the time available. I may be passing up a good opportunity. But I prefer taking a chance of doing that to putting any money into something re which I do not possess a deep understanding.

These foreign funds may be awesome for those who understand them well. Those who don’t will get thrown from the horse sooner or later. When you don’t possess deep understanding, you lack the confidence needed to get through hard times. And my view is that that is pretty much the entire deal. Once of the things that I love about Bogle is that he encourages regular people to keep it simple. By investing in only a small number of basic investment classes, you can get to understand those few investment classes well.

My view is that those who have not yet had the time to come to a deep understanding of the most basic asset classes should not be devoting any time to the less essential stuff. For sophisticated investors with lots of time for research, it’s a different story.


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