International Bonds
August 19, 2018
Should I own international bonds?
Bonds, not stocks, has the largest market capitalization and the foreign market for bonds is larger than the US bond market. As of 2012, just foreign bonds made up “more than 35% of the world’s investable assets.”[1] Yet, this asset class ignored by John Bogle, Warren Buffett, and Jim Collins who opt not to include international stocks or bonds in their recommendations. Even William Bernstein, the renowned neurologist and author, leaves international bonds out of his recommended portfolios.
On the other hand, Vanguard has included foreign bonds in their Target Date Retirement Funds and LifeStrategy Funds. As of 2018, these Vanguard funds target holding 30% of the bond portion of the funds in international bonds.
Since I had opted not to include bonds for simplicity and due to my willingness and ability to take on more risks, I had neglected further research into international bonds until now. Since I how hold foreign bonds in my 401k (as a result of choosing the Vanguard Target Date Retirement Fund 2060), it’s time to figure out why I own it.
Definitions
VTABX, VTIBX, BNDX
Edit(2021): Admiral shares are now available at a starting investment of $3000 which was the same as investor shares previously. We will be referring to the Vanguard funds for the purpose of this article. VTABX is the admiral shares and require a larger investment but offer a (almost negligible) lower cost than the investor shares (VTIBX) which are held in the Target Date Retirement and LifeStrategy funds. BNDX are the ETF equivalent of these index funds.
Hedged
These funds are hedged which means they try to remove the currency risk by capturing returns independent of the changes in exchange rate. That means that the relative strength of other currencies to the dollar should not affect the return of these funds.
Sampling
These bond funds use a sampling of the bonds in the index instead of replicating the index while trying to keep the key characteristics the same. According to the 2018 prospectus, the fund held 4590 bonds while the index had 8945 bonds.
Benefits
Diversification
Since foreign bonds are largely unaffected by factors that affect U.S. markets, they are uncorrelated and thus provide good diversification benefits.
“The volatility of currencies can overwhelm any diversification benefit that international bonds may bring to a diversified portfolio. On the other hand, with that currency risk hedged, an allocation to international bonds can lead to lower average portfolio volatility over time.” (17) [1]
The volatility of other currencies wiping out any diversification benefit is why Vanguard must use hedging for foreign bonds.
Disadvantages
Investing in international bonds carries the risks of bonds as well as those of foreign securities.
Bond Risks
Interest rate, credit, and inflation risks are chief among the risks of investing in bonds. We covered these risks in our article Bonds.
Foreign Investing Risks
Investing outside the United States introduces the risk of currency fluctuations and foreign political uncertainty.
The prospectus gives a reasonable reminder of these risks.
“U.S. investors who invest in foreign securities will encounter risks not typically associated with U.S. companies because foreign stock and bond markets operate differently from the U.S. markets. For instance, foreign companies and governments are not subject to the same accounting, auditing, legal, tax, and financial reporting standards and practices as U.S. companies and the U.S. government, and their stocks and bonds may not be as liquid as those of similar U.S. entities. In addition, foreign stock exchanges, brokers, companies, bond markets, and dealers may be subject to less government supervision and regulation than their counterparts in the United States. These factors, among others, could negatively affect the returns U.S. investors receive from foreign investments.”[2]
See our article Global Investing for more discussion about the risks of foreign investing.
In addition to the risks of investing in bonds and foreign securities which we may have already chosen to take if we hold the Total (US) Bond Market or Total International Stock Market funds, there are also some additional risks to consider.
Derivatives Risk
In order to hedge foreign currency exposure, Vanguard’s funds use forward exchange contracts which are “agreements to exchange currencies at a specified time in the future.”[3] I think these contracts are what Vanguard is referring to as the derivatives that add additional risk to the bond fund.
Currency Hedging and Sampling Risks
Although these funds try to perfectly hedge so that the currency exchange rate changes don’t affect the price changes of the fund, there is the danger of overhedging or underhedging relative to the foreign currency’s strength compared to the dollar which would cause the price of the fund to change. Also favorable changes in exchange rates would not benefit the fund.
Sampling is also considered a risk since the index is not perfectly tracked. The total US bond market fund also has sampling risk. Both of these risks are considered “low” according to the prospectus probably because of the large number of different foreign currencies and the large sampling of bonds included in the fund.
Nondiversification Risk
“The fund is considered nondiversified.”
My understanding of this warning is that a significant percentage of foreign bonds in the fund may largely be purchased from a few country governments. Thus, diversification is significantly reduced compared to stocks which are more equitably distributed between companies. For example the bulk of the U.S. total bond market is made up of bonds from the U.S. government.
Additional Costs
The turnover of this fund is 19% which is quite high compared to the 3% of the Vanguard Total Stock Market fund but lower than the staggering 55% of the Vanguard Total Bond Market fund.[4] [5] The high turnover is partially due to the maturity of bonds and the need to replace them with new bonds to maintain the average maturity of the fund.
Whereas we could stash our total US bond market fund in a tax-deferred account to avoid paying taxes on the dividends, forei
Tax Considerations
In managing taxes, we tried to put international stocks (VTIAX) in taxable accounts if we were contributing enough to fill tax-advantaged accounts with investments in the total U.S. stock market (VTSAX) and the total U.S. bond market. We prefer to place the bond market fund in tax-deferred accounts because the bond market is more tax inefficient and has lower expected returns. We prefer to place the asset with the highest expected rate of return in Roth accounts since those will no longer be taxed. Since international assets are taxed by foreign governments whether or not they are in an U.S. tax-advantaged account we leave those in taxable accounts. (Plus we get a foreign tax credit on our U.S. tax bill since we already paid foreign taxes.) [6]
With international bonds, since we will be taxed by foreign governments on dividends, we might as well leave these in a taxable account as well. We wouldn’t want to put these in a Roth account since they are not expected to have higher returns than stocks in the long run and we will still be being taxed by foreign governments. Although they are not as tax efficient relative to stock index funds due to the higher percentage of returns coming from dividends, placing them in tax-advantaged accounts can only shield our investments from the U.S. government.
Conclusion
Due to the complexity of international bonds and the additional risks, I am hesitant to invest in international bonds. The hedging of currencies drive expenses up.
However, I am willing to take the risk of investing in Vanguard Target Date Retirement Funds with a small percentage of these international bonds for the potential diversification benefits without stressing about deviating from my target allocation.
Resources
References
[1]Global fixed income: Considerations for U.S. Investors
[2]Vanguard Total International Bond Fund Summary Prospectus - A gem that I found in bold letters while reading through the prospectus: “Do not invest with Vanguard if you are a market-timer.”
[4]Vanguard U.S. Stock Index Large-Capitalization Funds Prospectus
[5]Vanguard Total Bond Market Index Fund Summary Prospectus
[6]Tax-efficient fund placement
Going global with bonds: The benefits of more global fixed income allocation