Is there a sweet spot for fixed-income diversification?
Yesterday I highlighted three funds I thought might help out most investor portfolios. One of the ones I highlighted was the Vanguard Total International Bond ETF (BNDX | B-57). I immediately got emails asking about alternatives, risks and emerging markets. So here's a deeper dive into the space.
First off, what's the actual point of adding international bonds to your portfolio? The answer is simple: diversification. I think investors all too often get so caught up in chasing what they think is going to be hot next year, that they forget the fundamental premises of modern portfolio theory: You want to own assets that aren't correlated, so that when one zigs, the other—hopefully—zags. Combining non-alike assets is a surefire winner for long-term risk management.
International bonds fit the bill in spades. Consider how the market stacks up in just one corner of the bond market—corporates:
|5 Year Correlation to …|
|Yield to Worst (%)||Effective Duration (Yr)||U.S. 10-Year Treasury||S&P 500|
|U.S. Investment Grade||3.16||6.85||0.59||0.09|
|Europe Investment Grade||1.26||4.85||-0.19||0.68|
|EM Investment Grade||3.82||5.54||0.31||0.37|
|U.S. High Yield||6.14||4.49||-0.26||0.73|
|Europe High Yield||4.44||3.55||-0.33||0.74|
|EM High Yield||8.14||4.02||-0.24||0.65|
These are all based on the BofA Merrill Lynch series, so it's about as apples-to-apples as you can get in the topsy-turvy world of bond indexing. That top line is the whole reason people reach for bonds at all—the U.S. investment-grade market has just a 0.09 correlation to the S&P 500.
That's about as diversified as you can get. But look at what you can get out there in the broader marketplace: negative correlations to the U.S. bond market, and in the case of emerging markets, some pretty juicy yields.
So what are your options in ETFs?
To come up with my truly international list, I excluded global funds, like the iShares Global High Yield Corporate Bond (GHYG | B), on the basis that it was heavily invested in the U.S. I also excluded "go anywhere" funds, like the PIMCO Total Return ETF (BOND | B), because of their "core" status in most investors' minds.
What you're left with is a pretty short list—some 40 ETFs covering international bonds of all kinds, and half of those are focused exclusively on emerging markets.
Here are the top 10: