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The Case for Non-U.S. Bond Diversification

U.S. bonds have generally outperformed non-U.S. bonds over the last decade. But is there more to the story?

Assorted flags from different countries.

Key Takeaways

Even though non-U.S. bonds have underperformed U.S. bonds for several years, that doesn’t mean they will continue to do so.

Currency effects play a significant role in non-U.S. bond performance, especially when considering the strength of the U.S. dollar.

There is a strong case for diversifying a portfolio with non-U.S. bonds when hedging out currency effects.

The broad U.S. taxable bond market has outperformed non-U.S. bonds meaningfully over the last 10 years or so. What’s more, it’s done so with less volatility. This begs the question, why should someone allocate to non-U.S. bonds at all?

Past (Bond) Performance Doesn’t Guarantee Future Returns

First, let’s recall the old line that past performance cannot reliably predict future returns.

We generally see this as a disclosure or warning to remind investors that good performers may not always continue on their positive trend. But it also means that lagging assets could still have the potential to turn their performance around.

Bond Returns vs. Currency Effects

Next, consider that the return and volatility numbers over the last decade did not hedge out currency effects. That means that they reflect currency returns and volatility in addition to the characteristics of the underlying bonds.

The U.S. dollar has been remarkably strong over that same period, so much of the underperformance of non-U.S. bonds and the excess volatility comes from currency movements. That’s because returns in foreign currencies are worth less when converted back into dollars following the greenback’s appreciation.

When we hedge out currency effects, non-U.S. bonds beat U.S. taxable bonds over that same time period—with lower volatility. So in general, the Sharpe ratio (a measure of risk-adjusted performance) of currency-hedged non-U.S. bond portfolios is higher than U.S.-only bond portfolios.

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Weighing Non-U.S. Bond Risks

When talking about non-U.S. bond exposure, it’s important to distinguish first whether you’re going to accept currency risk along with foreign interest rate risk or whether you’re going to decide to hedge it out.

Your second big decision is whether you want your non-U.S. bond exposure to include emerging markets bonds or not. Recently, emerging markets bond exposure has not aided returns, but it has done so over other time periods.

The Case for Non-U.S. Bond Diversification

Add it all up, and I think there’s a strong case for holding non-U.S. bond exposure on a strategic or longer-term basis simply for the diversification benefits. In this case, I’d argue for currency-hedged investments.

The argument for international diversification of your bond portfolio is very similar to the one made for your stock allocation, at least on a currency hedged basis. Even if the non-U.S. bond exposure yields somewhat lower returns over a given period of time, you still benefit by diversifying central bank monetary policies across the various regimes.

In other words, when the Federal Reserve is hiking rates, other countries’ central banks may have already begun to loosen monetary policy, and vice versa. So the volatility of returns of currency-hedged non-U.S. bond exposure is generally less than that of U.S.-only bond exposure.

And by investing in overseas fixed-income products, you are also buffering your portfolio against other U.S.-specific risk, like inflation.

Richard Weiss
Richard Weiss

Chief Investment Officer

Multi-Asset Strategies

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Diversification does not assure a profit nor does it protect against loss of principal.

International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.

Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.