Diversification is the name of the game in personal finance. For a long while, diversification meant a US stock fund paired with a US Bond fund. Then, when international investing became en vogue in the late 80s and early 90s (after a huge run-up, of course), it became common for experts to recommend splitting your equity allocation between domestic and foreign stock funds. Then after the dotcom bust of 2000, Real Estate Investment Trusts (REITs ) became popular for their diversification benefits (Im sure it had nothing to do with the bull market in real estate or anything). And while experts probably began touting these asset classes for the wrong reasons, they  were actually fairly decent diversifiers and todays investors are better off having included these asset classes in their portfolio. And today, the drumbeat of diversification marches on.

Enter International Bond Funds

Along with commodities. international bond funds seem to be the new hotness when it comes to asset classes. After all, Vanguard recently announced two new international bond index funds  and you know if stodgy old Vanguard is getting involved, its probably not just a short-term trend. So should you get involved? Any time youre considering adding a new asset class to your portfolio, there are a few important filters you should run it through first. Ive written an entire post about it if youre interested in the details, but heres the short-short version:

1. Returns commensurate with risk
2. Traded on highly liquid, public exchanges
3. Sufficiently regulated
4. Inexpensive and convenient way for small investors to gain access
5. Provide at least one specific diversification/investment benefit

Do international bonds meet all of the above criteria? I would say yes, most definitely. However, there are still some disadvantages of foreign bond funds relative to domestic bond funds so you shouldnt buy them blindly.

Pros Of International Bonds

• Imperfectly correlated to domestic bonds Obviously, the bonds of foreign countries (and especially foreign governments) will tend to track their local markets. Its true that most assets around the globe, including bonds, are becoming more correlated over time as globalization marches on, but they will never be perfectly correlated because the risks will always be at least partially local in nature.
• There are relatively inexpensive international bond mutual funds available Vanguards recent announcement provides inexpensive access to foreign government bonds in both developed and emerging markets. There are other decent funds out there, but Vanguards will be among the cheapest when they launch sometime in 2013.
• Currency diversification There are two types of foreign bond funds offered to US investors: hedged and unhedged.  International bonds may rise and fall for two primary reasons. As interest rates in the country of origin change, the bond rises and falls accordingly. In addition, exchange rate changes for bonds dominated in their countries currency affect the bond prices. In either case, some sovereign bonds may choose to hedge against these risks while others do not, but some such as PIMCO offer both hedged and unhedged foreign bond funds. There are pros and cons to hedged and unhedged bond funds, of course, but my advice is to always use a hedged international bond funds (as most of the options out there are). You already have decent foreign currency exposure with your foreign equity holdings. Bond are primarily for safety, not speculating on currency movements.

Cons of International Bonds

• Theyre still significantly more expensive than domestic funds Vanguards new funds will debut with expense ratios in the 0.40-0.50% range, which other existing options even higher. Thats more than twice what youd pay for a good domestic bond index fund.
• The diversification benefits are likely to be moderate at best As mentioned above, global capital markets are becoming more correlated all the time. At best, and this is purely a guess, you can expect international bond funds to be only modestly correlated to domestic bonds. Gone are the days when European bonds were negatively correlated with Japanese bonds over long periods of time.
• Currency hedging isnt free Hedging foreign currency exposure isnt free, and its a cost that isnt reflected in the expense ratio. Just be aware your true costs will be somewhat higher than the stated ER.

So Whats The Verdict?

Foreign bonds, especially foreign government bonds, are a viable asset class whose time may have come. It all comes down to the same trade-off most other investing decisions come down to: is the extra potential diversification benefit worth the extra costs involved? Theres no way to know for sure, of course. I would say that for large portfolios (were talking high seven figures and above) its probably worth the somewhat higher costs because at that point, youre probably more concerned with keeping what you have than growing your wealth at the highest possible rate. For those with smaller portfolios, I would say its probably  not worth it yet. I myself dont plan to diversify into international bonds until one of two things happens:

If you are wondering what may be the best international bond funds, my previous advice on comparing mutual fund performance applies here quite well (hint: sign up for a free Morningstar account ).