According to Nicholas Sanders, a bond-fund manager at Alliance Bernstein, relying solely on US bonds is an outdated strategy. In a recent memo, he highlights the changing dynamics of the global bond market. The United States now accounts for less than a third of the world’s bond universe, and the global bond market presents a wider range of opportunities and diversification sources.
Sanders believes that international bonds, when hedged back into US dollars to mitigate currency fluctuations, have outperformed US bonds over the past three decades. Not only have they delivered higher returns, but they have also exhibited lower volatility. Although the gap in returns may seem small at first glance (4.8% versus 4.6% per year since 1993), over 30 years, it adds up significantly, translating to a 308% profit compared to 285% for US bonds.
For ordinary investors looking to access these international bonds, low-cost mutual funds or index funds offered by companies like Vanguard provide an easy entry point. Vanguard’s International Bond Index exchange-traded fund (ETF) BNDX, which hedges currency risks like other international bond funds, has outperformed its domestic counterpart, Vanguard Bond Index ETF BND, over the past decade.
While the margin may appear modest (0.6 percentage points per year), it is substantial in the context of current market conditions: 1.9% versus 1.3% annually. In an era of diminished returns, the international fund has generated an additional half of its counterpart’s annual returns.
By embracing international bonds as part of their investment strategy, retirees, near-retirees, and risk-averse individuals can potentially enhance their portfolios. Diversifying beyond US bonds opens doors to a more expansive and varied investment landscape, offering the chance for improved returns and reduced volatility. So, perhaps it’s time to reconsider our bond investments and explore the benefits of global opportunities.
International Bond Funds: A Safer Investment Option
International bond funds have gained significant popularity due to their impressive performance and lower volatility. When comparing returns with volatility using the Sharpe Ratio, these funds have consistently outperformed their counterparts.
Currency hedging is a unique feature of international bond funds. Hedging involves the use of derivatives to protect U.S. investors from currency fluctuations. This ensures that even if the value of an international bond decreases due to a currency depreciation, investors are still able to earn stable returns.
While there is an ongoing debate in finance about whether it is beneficial to hedge international stock funds, hedging in bond funds has become the norm for various technical reasons. Surprisingly, hedging not only shields investors from currency movements but also generates additional income. In today’s market, a hedged international bond fund offers a higher yield compared to equivalent U.S. funds.
However, past performance should not be the sole reason for investing in international bonds. Investors are more focused on future performance and reducing risk through diversification. Owning bonds from various markets, just like diversifying stocks, provides a more stable investment portfolio.
Recognizing the importance of diversification, Vanguard has introduced the world bond fund BNDW, which evenly allocates investments between U.S. and international funds.
Contrary to popular belief, international bonds are not risky investments. In fact, investors who solely rely on U.S. bonds are exposing themselves to greater risk and missing out on the vast opportunities presented by diversification.
Furthermore, if investors need one more reason to diversify away from the U.S., they need not look further than Washington’s consistent debt-ceiling fiascos. As someone once humorously said, the U.S. sometimes resembles a “banana republic without bananas.”
By considering international bond funds, investors can enjoy safer and more diversified investment opportunities that can potentially yield higher returns in the long run.