Just like diversifying a stock portfolio across different borders, going global with bonds can provide lower correlations and raise prospects for greater long-term returns.
That might sound contrary to what some advisers are saying these days. In 2008, critics of the benefits of diversification came out of the woodwork as correlations among most major asset classes collided to 1.
However, a wealth of academic and real-world evidence strongly suggests that country- or region-specific events causing downturns can be softened by global diversification in stock portfolios.
It just stands to reason that as the ongoing credit crisis unwinds, investors should be able to reap long-term benefits from diversifying their debt portfolios as well.
The exchange-traded funds industry certainly has heard the call for international bonds. Despite difficulty in accessing some of these markets, the low-correlation benefits when compared to U.S. Treasuries are making these types of funds attractive to sponsors—in terms of providing more tools for long-term individual investors as well as institutions.
This year, iShares issued two international Treasury bond ETFs, tracking indexes covering Treasury bond issues from developed countries around the world excluding the U.S. Those are the S&P/Citigroup International Treasury Bond Fund (Nasdaq: IGOV) and the S&P/Citigroup 1-3 Year International Treasury Bond Fund (Nasdaq: ISHG).
State Street Global Advisors has a similar ETF lineup in the international developed sovereign debt space with the SPDR Barclays Capital International Treasury Bond ETF (NYSEArca: BWX) and the SPDR Barclays Capital Short Term International Treasury Bond ETF (NYSEArca: BWZ).
Globally Diversifying Bonds
International Treasury bonds of developed countries have very little credit risk; however, the risk of default is not zero, and sovereign risks of each country should be taken into account. Paul Amery wrote on the increasing default risks in European countries as seen through the five-year spread in credit default securities. (See the story, "Sovereign Default Risks On The Rise.")
Using international bonds in a portfolio can add diversification by spreading out the sensitivity of U.S. interest rate movements which affect bond prices. International governments will have different monetary policies and interest rates that will affect that government's Treasury bond prices differently.
International treasury bonds included in these ETFs are issued in local currency, unlike some emerging market bond ETFs that include only developing country government issued debt in the U.S. dollar.
The chart below displays U.S. Treasury annual returns versus global Treasuries in developed markets. Representing U.S. Treasuries is the Morningstar U.S. Treasury Bond Index, which includes U.S. Treasuries with maturities greater than one year and $1 billion outstanding.
Global Treasuries are represented by the Morningstar Global ex-U.S. Government Bond Index, which is similar to the makeup of the international ETF's respective indexes. There is also a variation to the index that hedges the currency fluctuations and makes an interesting illustration.
Looking at the gap between the U.S. dollar un-hedged and hedged Global Government Bond Indexes shows the effect currency has played in the annual returns in the past within this category.
In most years, outside of first quarter 2009 and 2005, currency, or the difference between the unhedged and hedge indexes, benefited the U.S. investor.
Currency exchange movements are hard to predict, and the pattern of a falling U.S. dollar to other major currencies which has caused many foreign assets to outperform comparable U.S. assets may not continue in the future. Investor need to be aware that currencies seem to be a major driver of returns in the above chart, and potentially for the ETFs that cover this asset class.
Using the same indexes from the above chart, correlations show how significant the diversification effect would be for an investor adding international developed Treasury bonds to a portfolio of U.S. Treasuries. According to Morningstar, the correlation of return between the hedged index (without currency fluctuations) and U.S. Treasuries was .81 over the last five years. Currency seemed to significantly lower the correlation in both cases.