This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Robert Leggett, senior portfolio advisor at Akron, Ohio-based ValMark Advisers, which markets the "TOPS" brand of asset allocation models.
The benefits of international bond ETFs mean investors really ought to include them in diversified long-term strategic portfolios. According to our research, diversifying bond holdings internationally can reduce several types of risk, including sovereign, currency, credit, interest rate and inflation risks.
The act of literally broadening an investor’s horizons to include international bonds thus creates a unique opportunity to enhance risk-adjusted returns.
That said, now may not be an opportune time for an overweight tactical allocation, due to:
- Upward pressure on the dollar
- Relatively low bond yields in many foreign markets
- Relatively easier monetary policies of many foreign central banks
That points to possibly reducing international bond exposure and, if international bond allocations are still a priority, making use of international bond ETFs like the Vanguard Total International Bond ETF (BNDX | B-57), which is hedged back to the dollar. But first, let’s get a bit more into these three big factors I outlined above.
Unhedged international bond allocations benefited U.S. investors in recent decades because foreign bond yields were generally higher, and the dollar declined in value versus many currencies.
But several major currencies have recently undergone systematic and arguably planned debasement. The resulting currency volatility and dollar strength caused many investors to consider currency hedges for their international bond investments.
Still, advisors should recognize that the apparent risk-reduction move of hedging foreign currencies might have unintended consequences. By moving allocations to 100 percent dollar exposure, the risk-dampening correlation of international bonds is altered.
But given the strengthening trend of the dollar, we believe the use of currency-hedged fixed-income ETFs should be considered by investors using international bonds.
Lower Bond Yields
Currently, some sovereign international bonds are paying lower interest rates than domestic bonds. The 10-year German Treasury note has recently been yielding less than 0.70 percent, while the U.S. counterpart is yielding more than three times that amount at around 2.1 percent. Likewise, many developed international markets are also experiencing extremely low inflation, which would potentially signal that monetary policymakers like the European Central Bank don’t need to raise rates any time soon.
Central Bank Policies
The U.S. Federal Reserve has ended its quantitative easing (QE) program and is contemplating higher interest rates in 2015. In contrast, several foreign central banks are initiating or expanding QE and are cutting interest rates due to slow economic growth and falling inflation rates.
ETFs Are The Way To Go
In a world of historically low interest rates, it’s very difficult for investors to formulate strategies that improve their chances of beating inflation without assuming undue risk. Our team has often said: “More money has been lost chasing yield than at the edge of a sword.”
While battling the urge to chase yield and the risk associated with that pursuit, we follow our disciplined process. Each strategy’s reward must be balanced to provide the desired result. For instance, owning longer maturity bonds may improve income with the yield curve positive. But the purchasing power of principal is at risk of inflation rises.
Buying lower-quality bonds may also improve portfolio yield, but that clearly increases the risk of loss of principal. Diversifying into non-U.S. bonds is another avenue of potential risk/reward enhancement.
Historic drawbacks for international bond investing included a lack of liquidity, knowledge deficits on individual securities, custody costs and transaction costs. These can be largely overcome by using international bond ETFs rather than purchasing individual securities, as these ETFs allow investors to establish, monitor and effectively manage international fixed-income allocations.
For that matter, we feel most investors are better off if they use ETFs rather than individual securities for domestic investments as well.