Diversification, But at What Cost?

As yields on high-quality bonds slip in the United States, more investors are turning to foreign bonds and foreign bond funds to boost portfolio yield and provide more diversification. Although foreign bond funds offer advantages, especially in a global economy in which the dollar is falling versus foreign currencies, you should be aware of several risks before taking the plunge.

Investing in assets denominated in other currencies carries inherent risks. There’s also the chance foreign governments will follow the United States and cut interest rates. And political turmoil hurts bond values.

For William Gamble, author of Freedom: America’s Competitive Advantage in the Global Market (Praeger Publishers, 2007), the risks far outweigh the potential advantages. This is especially the case with China and other formerly hot global markets cooling off.

“The very real possibility of inflation and recession in the global economy in the short term makes investment in foreign bonds even more dangerous,” he says. “If inflation gets out of control, international bonds will tank. And as the recession deepens, local currencies will probably not match a recovery of the dollar, which will profit from a flight to quality. A few hundred basis points are not worth the risk.”

Many experts disagree with Gamble, noting that buying shares in a well-diversified international bond fund will dilute the primary risks.

“There are significant diversification benefits to be earned by investing in foreign bond funds,” says Walter J. Schubert, Ph.D. a finance professor at La Salle University in Philadelphia. “Since economies do not move perfectly together, we should expect bond market diversification benefits from being globally invested.

“The biggest bang for your diversification buck, however, occurs in the bonds of developing countries, because their economies are likely to be less correlated with ours. The other side of the problem is the potential default risk.”

Should you decide to invest in a foreign bond fund, keep the potentially significant downside in mind when determining how much to acquire. To hedge your risk, you could opt for a global bond fund that invests in both U.S. and foreign bonds or for an international bond fund with high average credit quality and a smaller percentage of holdings in emerging markets. No matter what you decide, remember that international stock funds also offer exposure to international economies, as do funds that hold multinational corporations.

Risk on Three Fronts

When considering adding a foreign bond fund to your portfolio, you’ll need to weigh several factors.

Foreign currencies. When foreign currencies such as the euro, yen and yuan gain value relative to the U.S. dollar, investments denominated in these currencies generally receive a boost. The gains from exchange rates might distort the true performance of foreign bond funds. Also, not all bond funds benefit when foreign currencies rise; some funds hedge against foreign currency exposure to reduce volatility.

Over the long term, funds that don’t hedge perform about the same as funds that do, studies say. But if the dollar continues to fall, funds that don’t hedge are likely to benefit.

“You’re also more likely to gain more over the long term if you don’t hedge out the currency exchange risk,” Schubert says. “It isn’t free to do such hedging, and the long-term results should be about the same whether one hedges or not. Hedging makes the results less variable but is not likely to improve them over time.”

Political turmoil. This risk is especially present in emerging markets, where governments are more likely to be unstable or dictatorial. Gamble is more concerned about the lack of regulation and the difficulties bondholders likely would have navigating court systems in foreign countries.

“Diversification and asset allocation are all well and good, but [these ideas] are flawed when they’re based on the assumption that all markets are the same,” he says. “When markets don’t function based on regulation and rules but rather on relationships, they’re more subject to bubbles, and investors — especially in credit instruments — are more likely to get burned.” Governments in emerging markets have especially little incentive to adhere to rules and regulations.

Inflation and interest rates. With commodity prices rising globally, inflation is a risk worldwide. As inflation rises, bonds that have already been issued lose value in the secondary market. In this environment bonds issued more recently are usually more attractive because they’ll have higher interest rates, as central banks such as the U.S. Federal Reserve and European Central Bank often raise rates in response to inflation fears.

With oil prices settling in at more than $100 a barrel and gold prices currently exceeding $1,000 per ounce, inflation is by no means under control and could damage foreign bonds and the governments and corporations that issue them.

“Inflation normally goes down in a recession, but the Asian economies are just beginning to weaken, so demand for commodities and inflation are still high,” Gamble says. “Inflation is more than 20 percent a year in Argentina and Venezuela. It’s rising in China, Russia and the Middle East.”

Keys to Fund Selection

Institutional investors are more likely than individual investors to take advantage of the diversification offered by foreign bonds, says Peter Miralles, president of Atlanta Wealth Consultants. “Looking at the models of the superendowments such as Yale and Harvard University, we find that on average they include a 12-percent allocation to global bonds,” he says. “The allocation in an individual investor’s portfolio depends on the investor’s risk tolerance and time horizon, just like any other investor.”

If you’re determined to take the plunge into international bond funds, you’ll find that actively managed funds dominate this sector. But several index funds offer a low-cost alternative, as does a new exchange-traded fund. The SPDR Lehman International Treasury Bond ETF (ticker: BWX), which attempts to reflect the performance of the Lehman Brothers Global Treasury Ex-U.S. Capped index, invests in bonds from 11 countries, including Japan, Italy, Spain and the United Kingdom. (Investments mentioned are for educational purposes only. No recommendation is intended.)

When considering investing in an actively managed fund, pay attention to these factors:

• Management. Management experience and depth is vital in this arena, Miralles says. “I would recommend a manager who has economists, analysts and specialists on the ground in a variety of countries,” he says. Look for a manager with a minimum of five years’ experience who has a consistent investment strategy.

• Diversification. A fund diversified by country and type of bond is ideal. The safest bet often is a fund that concentrates its investments in government bonds in developed, politically stable countries. As Schubert notes, emerging markets offer the best potential for diversification but are also riskier. So if you have any exposure to developing-country bonds but don’t have the appetite for risk, you might want to limit how much you own.

• Long-term performance. Many bond investors pay too much attention to yield, Miralles says, while a better measurement is long-term total return. Examine average annual total return — interest plus capital gains — for the past five and 10 years versus a comparable market benchmark.

• Costs. Costs are going to be higher for international bond funds than for domestic bond funds because of the additional costs involved in researching and purchasing foreign bonds. Bearing this in mind, if two funds are equal in terms of past performance and management, choose the lower-cost option, as it will benefit your returns more over the long term.

Avoiding the Middleman

In the United States, it can make sense to bypass funds in favor of a direct investment in bonds, especially for government issues such as Treasury securities. After all, if you can get a better deal by cutting out the middleman, why not do it?

Unfortunately, most foreign governments offer no such comparable plan. And the inventory of foreign bonds at U.S. brokerages generally ranges from slim to none.

If that wasn’t enough to turn you off, you have to choose from a bewildering number of options in foreign government and corporate bond issues. Finally, you have to deal with differences in currencies. So if you believe you need foreign bonds for your portfolio, a fund is likely the best choice.