Brett Arends's ROI

We’re investing in bonds all wrong

Why do investors seeking stability typically invest only in U.S. bonds?

Not that kind of bond.

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Why do retirees, near-retirees and others seeking stability typically invest only in U.S. bonds — whether they be U.S. Treasury bonds or corporate bonds? (Municipal bonds, for their tax breaks, are a special case.)?Why are bonds that are issued in developed foreign countries — like Japan or Germany or Great Britain — somehow seen as more risky or unusual?

Any financial expert fluent in Reverse Polish (don’t ask) could tell you that real risk comes from needlessly missing out on chances for diversification — which, as they say on Wall Street, is the only free lunch in town.

If we’re only putting our money into U.S. bonds, are we doing it wrong?

Pretty much, Alliance Bernstein bond-fund manager Nicholas Sanders says in a new memo.

“Gone are the days when the U.S. fixed-income market dominated the world’s supply of bonds,” he writes. “Today, the U.S. represents less than a third of the global bond universe. And the global bond market is much more diverse than the U.S. bond market. Not only does it offer more opportunities from which an active manager can choose, but its differing landscapes provide significant variety and diversification sources.”

International bonds, when hedged back into U.S. dollars (to protect you from currency fluctuations), have been a better investment for the last 30 years than U.S. bonds, he adds: They’ve produced higher returns with lower volatility.

There isn’t much in the return gap: 4.8% a year versus 4.6% a year since 1993. Over 30 years, though even that adds up, generating 308% profit against 285%. The volatility, meanwhile, has been much lower.?

The simplest way for normal people to invest in these things is through low-cost mutual funds or index funds, such as those offered by Vanguard. As it happens, it’s been just over 10 years since Vanguard launched its International Bond Index exchange-traded fund BNDX, which, like many international bond funds, hedges currency risks.

Over those?10?years, the ETF has beaten the domestic U.S. bond version, Vanguard Bond Index ETF BND, by a clear margin.

It doesn’t sound like much: 0.6 percentage points a year. But it’s pretty big in context: 1.9% versus 1.3% a year. In an era of meager returns, the international fund has generated half as much again in annual returns.

And, once again, it’s done that with less volatility. When you use something called the Sharpe Ratio, which compares return with volatility, the international bond fund has been way, way better.?

The currency hedging is a curious feature of international bond funds. Hedging means using derivatives to shield U.S. investors from any currency fluctuations. Otherwise, if you own an international bond paying 5% interest but that country’s currency falls 5% against the dollar, you’ve effectively?made?bupkis.?

There’s a long-running and unresolved debate in finance about whether it’s better to hedge the currencies of your international stock funds.?But in bond funds it seems to be the standard M.O., for various technical reasons.

Hedging, bizarrely, can do more than shield you from currency moves, it?can also generate income. In current markets, Sanders writes, a hedged international bond fund will generate a higher yield than the equivalent fund in the U.S.

The past performance of international bonds, while perhaps surprising, isn’t the reason to own them. Investors are concerned with the future, not the past. But the logic seems pretty sound. It’s hard to argue against more diversification, in bonds as well as stocks.

Vanguard now has a world bond fund BNDW that is split pretty much equally between its U.S. and international funds.

International bonds may seem risky, but the truth is the reverse: It is those investors who keep all their money in U.S. bonds who are taking on more risk — or, more accurately, missing out on a vast opportunity to lower their risks by diversifying.?

Oh, and without wanting to make too much of this, if you want a good reason you might want to diversify out of the U.S., look no further than Washington, which is — yet again — racing towards another debt-ceiling fiasco.?

The U.S., a wit once said, sometimes looks like “a banana republic without bananas.”