December 2007, Wealth Manager
Portfolio strategy that neglects foreign bonds may be comfortable, but it can be costly, too.
By James Picerno
Stocks and Bonds, Bonds and Stocks.
Asset allocation starts with this fundamental
mix, and for good reason. Low correlation
prevails between the two asset classes—and
for enduring economic reasons. No wonder
that adding bond exposure to a portfolio of
stocks usually brings superior risk-adjusted
expected returns compared to owning either
Investors generally accept the logic of the
stock/bond diversification, and many extend
the strategy to foreign equities. Bond
allocations, by contrast, favor the domestic
market. “People tend to have a home bias,”
says Christopher Lazzaro, vice president of
financial advisor relations at Boston money
manager Loomis Sayles & Co.
History, however, suggests the home bias
is a mistake. The diversification benefits of
foreign bonds are potent, or at least they
have been in the past. Non-U.S. debt securities
post low trailing correlations with most
of the major asset classes, including U.S.
and foreign stocks, commodities and REITs.
Foreign bonds also move with a fair degree
of independence against U.S. bonds. The
basic reason is that economic and inflation
cycles—the driving forces of bond returns—
vary quite a bit from nation to nation and
region to region.
That’s good news since finding asset
classes with low correlations is job one for
building superior portfolios on a risk-adjusted
basis. By that standard, there’s a strong
case for owning foreign bonds in a diversified
portfolio. Yet the asset class is largely
ignored by U.S. investors, or so it appears
based on mutual fund assets.
Morningstar’s world bond and emerging
markets bond categories for open-end funds
collectively held $72 billion as of this past
August, a fraction of the $1.5 trillion for international
equity funds. ETFs add another
$3 billion to the foreign debt space. That’s
mostly in currency funds, although the first
foreign bond ETFs were launched in October.
The SPDR Lehman International Treasury
Bond (Amex: BWX) targets non-U.S. investment-
grade government debt. Another October
arrival wass PowerShares Emerging
Markets Sovereign Debt ETF (Amex: PCY),
which focuses on bonds issued in the developing
For the moment, however, publicly traded
funds in the offshore bond space are still a
drop in what is a very large asset class bucket.
Let’s be generous and say that foreign bond
mutual funds and ETFs add up to $100 billion.
That still looks like a rounding error in a
world of $20 trillion of outstanding non-U.S.
debt securities with maturities of one-year
or more as of this past March, according to
the Bank for International Settlements.
Investors who adopted a bond allocation
prescribed by the share of non-U.S. bond
issuance would have a fixed-income mix of
53 percent foreign and 47 percent domestic.
It’s a safe assumption that relatively few
U.S. investors follow Mr. Market’s instructions
to that degree. One reason, suggests
Morningstar analyst Michael Breen, is that
foreign bonds don’t resonate with retail investors
compared to foreign stocks. “There
are several different layers to the [foreign
bond] onion and it’s an esoteric onion to
The layers include foreign currencies, sovereign
versus corporate debt, and emerging
market versus developed market. Yes, overseas
equities are complicated too, although
Breen reasons that investors are more comfortable
with stocks generally. To the extent
that they need or want bonds, Treasuries
and domestic corporates are widely considered
adequate. Foreign debt, as a result, is
minimized if not ignored outright.
The myopia has come at the price of a sizable
opportunity cost in the past. Consider
the Foreign Affairs table below, which compares
the trailing three-year correlations
of the major asset classes. Clearly, foreign
bonds have packed a diversification punch
across the asset class spectrum.
In recent years, Citi Non-$ World Government
Bond Index’s returns (in unhedged
dollar terms) had no correlation with U.S.
stocks (S&P 500) and low correlation with foreign
equities (MSCI EAFE) and commodities
(DJ-AIG Commodity), according to Morningstar
Principia. Perhaps more remarkable is
the fact that foreign government bonds also
displayed low correlation with U.S. bonds
(Lehman U.S. Aggregate). The lesson is that
domestic fixed income is no substitute for
As a subset of foreign bonds, emerging
market debt is a potent diversifier, too. The
Citi ESBI Capped Brady (a benchmark for
developing nation bonds) posted low to
near zero correlations with the major asset
classes for the three years through this past
August. And if you think that emerging market
bonds are just a stand-in for emerging
market stocks, think again: Correlations
have also been low between those two corners
of the capital markets.
While the case for foreign bonds as a strategic
holding is compelling on paper, it’s a
bit more complicated in practice. One reason
is that this corner of the global capital markets
pie is still dominated by active management.
That may be changing, as the new
foreign bond ETFs suggest. But for the moment,
indexing is the exception, which for
many means choosing an active manager.
Alas, the active choices are limited.
Morningstar Principia lists just 83 world
bond mutual funds and 25 emerging market
bond funds (based on distinct portfolios
excluding share classes). If you restrict
the list to funds with at least five years of
history, the population drops to 70 funds
for both categories.
Meanwhile, bonds generally are considered
the calmer asset class next to stocks.
But there’s a wide band of results in this
corner. Recent three-year annualized returns
for foreign bond funds varied by 1,000
basis points from best to worst. In short,
manager skill counts a lot! (For the leading
foreign bond funds ranked by Sharpe
ratios, see the table below.)
Foreign currency is also a critical factor
in foreign bond funds. This is true for foreign
equity funds, of course, although—
for good or ill—currency has the potential
to be a bigger influence for overseas debt
securities. Bonds generally have lower expected
returns than equities, which is another
way of saying that bonds have fewer
opportunities for overcoming any foreign
exchange-related losses. That’s especially
true for foreign government debt in the developed
world, where credit ratings tend to
be higher and so volatility and returns are
often relatively lower.
That leaves the question: To hedge or
not to hedge the foreign currency factor?
The simple answer can be reduced to another
question: What’s your outlook for
There are two basic schools of thought
on hedging. One recommends hedging
most or all of future forex volatility. The
logic is that the historical record shows
forex as a performance wash over time.
If the expected return of foreign currency
exposure is zero, why suffer the additional
short-term volatility that comes with an unhedged
portfolio? In short, avoid the agony
by hedging completely.
Consider the Federal Reserve’s index of
major currencies, which is a weighted average
of the dollar’s value. By that standard,
the dollar has traded in a fairly tight band
for the last 20 years. In fact, the Fed’s major
currencies index is virtually unchanged for
the 12 years through this past August.
Over shorter periods, however, the dollar
can be volatile. The Fed’s major currencies
index was down more than 30 percent as of
this past August from its previous peak in
The alternative view is that forex exposure
is worthwhile because it’s part of the diversification
argument. Adopting that view translates
into limited currency hedging, if any.
That’s generally how Loomis Sayles treats
currencies in its global bond portfolios. Minimal
currency hedging is a key driver of the
diversification benefits with foreign bonds,
In fact, there’s evidence for both sides of
the debate. Like the old saying goes, if you
torture the data long enough, it will say almost
But no matter your view, there’s no escaping
the currency factor with foreign investing.
Both hedged and unhedged choices
carry an embedded forex bet when investing
a) U.S.-dollar-based investors who don’t
hedge will receive a currency-related performance
boost when the dollar falls—or a performance
drag when the buck rises.
b) Hedged investors are immune to forex,
a choice that effectively gives up additional
return in a period of dollar weakness. On the
other hand, the hedged investor sidesteps
forex losses when the dollar is strong.
A third choice effectively offers a middle
way between the two extremes: targeting
currencies as a separate asset class with
varying levels of active management. This
is an increasingly popular choice for institutional
strategies that fall under the heading
of global tactical asset allocation.
When it comes to mutual funds, the majority
choose to hedge, but in degrees that
vary widely. The shades of gray rarely go to
extremes, and so it’s the rare portfolio that’s
always fully hedged or fully unhedged.
Another issue to watch when tapping offshore
bond funds: Minimizing overlap with
any existing domestic fixed-income investments.
Many portfolios in the world bond
fund category avail themselves of U.S. fixed income
Yes, foreign bond investing adds extra layers
of complexity and risk compared to domestic-
only strategies. And history teaches
that the superior asset allocation strategies
over time tend to be the most emotionally
distressing ones in the short run. Comfort
has its price.