Potential Portfolio Challenges
There are three key portfolio design challenges that come from the heavy use of international bonds in domestic corporate bond ETFs.
First, investors using international bonds in their portfolios may end up with a higher exposure than desired. Second, a decision to overweight corporate bonds, relative to Treasurys, increases the international-bond allocation. Third, some of the ETFs have country allocations that represent a major departure from international bond indexes.
The first challenge is that the international bonds embedded in the funds in Table 1 represent an exposure to an asset class that is greater than many investors care to own.
As demonstrated in the “Allocation 1” table below, a moderately conservative asset allocation may put 60 percent in bonds, 48 percent in a broad U.S. aggregate bond ETF, and 12 percent in a targeted international bond.
|Fund||Allocation %||% Intl Bond||Intl Bond Exposure|
|Total Bond Market (US Index)||48%||7%||3%|
|Allocation 1 Bond Portfolio||60%||15%|
These sample allocations are meant to serve as examples. Actual holdings may differ.
In addition to the explicit 12 percent allocation, the portfolio picks up another 3 percent from the 48 percent allocation to a total bond market index fund. That gives the client a total of 15 percent allocated to international bonds, rather than the desired 12 percent allocation.
Of even greater concern is that the decision to overweight corporate bonds naturally increases the international bond allocation.
Since the Federal Reserve has purchased such a large portion of the low-yield Treasurys, many investors have lost interest in this asset class. Some investors are seeking to maintain income in a low-rate environment, and are using corporate bonds to boost the yield of their portfolios.
When investors use bond ETFs for this purpose, “Table 1” at the outset shows they’re purchasing sizable chunks of international bonds at the same time they’re reducing the 100 percent U.S. allocated Treasurys and mortgages included in U.S. total bond market ETFs.
If a client should choose to adjust the allocation toward U.S. credit by combining all the bonds into the iShares U.S. Credit Bond ETF (CRED) mentioned earlier, they would actually have increased their international bond allocation to 18 percent, as displayed in the “Allocation 2” table below. While the portfolio has a greater exposure to corporate bonds, the allocation to international bonds is 18 percent and increases by 3 percentage points over the more diversified portfolio.