Spreading your fixed income allocation outside the U.S. provides you with access to a wide range of opportunities
Seeking Yield and Currency
"International bonds have come a long way over the last five to 10 years," says Chris Dillon, a fixed income portfolio specialist at T. Rowe Price. "The complexity and number of offerings, access to information, and the breadth and depth of the asset class also have grown tremendously. For these reasons, it’s important to approach this asset class carefully."
Foreign fixed income securities make up more than 60% of the worldwide bond market, so investors who look only at the U.S. market could be missing significant opportunities for diversification. International bond markets include developed as well as emerging markets, some of which currently offer higher yields than those available in the U.S. And exposure to multiple currencies also can help to diversify a portfolio away from a focus on the U.S. dollar. The strong performance of international bond markets over the past 10 years, for example, would have benefited a portfolio exposed to these foreign markets. (See "The Performance of U.S. vs. Foreign Bonds." below) Overall, Dillon sees the current, positive trend continuing in foreign bond markets. "The Federal Reserve’s policy of quantitative easing has left many investors with the impression that there could be a secular decline in the value of the U.S. dollar," he explains. "This may benefit international bonds, which can be expected to produce better returns in a sustained period of dollar weakness." Of course, diversification cannot assure a profit or protect against losses in a declining market.
Higher Return Potential, Higher Risk
As the chart shows, there are trade-offs to the return potential afforded by foreign bonds, as measured by standard deviation (a common measure of investment risk). Like U.S. bonds, foreign bonds are subject to credit risk and interest rate risk. They’re also exposed to a risk that is unique to international investing—the volatility of currency exchange rates. Bonds from emerging markets are vulnerable to political and economic instability as well. "International bonds possess different and, in some respects, higher risks than domestic bonds," says Dillon. "With this higher risk, however, we still see many opportunities with greater return potential."How to Buy International Bonds
Mutual funds may offer the best opportunity to capitalize on the potential of foreign bonds. When evaluating possible investments, keep in mind that international funds typically invest outside the U.S., while global funds hold both U.S. and foreign bonds. "International fixed income markets can be extremely complex," Dillon notes. "Individual investors might not be able to gain access to all the markets—and if they did, they might not have the time or the information necessary to respond quickly enough to changes that would affect their holdings." For instance, what should individual investors do now that Brazil has increased its financial transaction tax to 6%? If they aren’t familiar with the Brazilian economy or don’t have access to a global trading or research platform, a professionally managed mutual fund that can adjust quickly to shifts in local policies and economic conditions might make more sense for their investment needs.
*Annualized data. Standard deviation is calculated using monthly data. This chart is shown for illustrative purposes only and does not represent the performance of any specific security. Past performance cannot guarantee future results. Source: T. Rowe Price.