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International bonds represent the largest global asset class, so it’s hard to justify their absence from a diversified portfolio. But what level of exposure is appropriate for an investor’s risk-tolerance level? And what role do foreign currencies play?

My firm’s research shows adding international bonds to an investor’s portfolio can help reduce portfolio volatility, assuming the currency exposure is hedged and the portfolio already has significant domestic fixed income exposure.

Why going global makes sense

Global bonds allow an investor to achieve exposure to the interest rate profile, inflation and economic cycles, and political climate of markets outside Canada.

Relative to a Canadian investment, some of these exposures might seem to add risk. After all, many would argue that Canada is a reasonably stable, developed economy and, therefore, likely to provide safe fixed-income investments.

But a global allocation may reduce the risk of an investor’s fixed-income portfolio without necessarily decreasing expected return.

Even though an issuer’s bonds may be more volatile than comparable Canadian bonds, an investment that includes the bonds of all countries and issuers would benefit from any imperfect correlations.

Read: Global economy braced by central banks

Correlation of quarterly changes in government bond yields, January 1970 to June 2013

Correlation of quarterly changes in government bond yields, January 1970 to June 2013 chart

Of course, investing outside of one’s domestic market entails owning bonds that pay interest and principal in other currencies.

This adds a wrinkle to the diversification benefit that might be expected.

The currency question

Interest and principal payments need to be converted from the issuer’s currency into Canadian dollars at future exchange rates. Although currency movements tend to be driven by fundamental factors over long horizons, currencies deviate significantly from fair value in the short to intermediate term. This creates return volatility above the level inherent to the underlying bonds.

Read: A tour of global markets

Currency exposure tends to overwhelm the attractive and potentially diversifying characteristics of international bonds. For that reason, investors interested in diversifying their fixed-income portfolios should consider investing in a fund that employs currency hedging as part of its investment process.

If the currency exposure is unhedged, the resulting currency volatility could outweigh the benefits of the lower volatility provided by the attractive correlations.

Whether an investor pursues a hedged or unhedged strategy depends on his goals. So advisors must clarify which type of exposure a client is seeking and help him determine the best way to obtain exposure.

  • If a client wants exposure to international debt and reduced portfolio volatility, investing in a hedged ETF gives him pure exposure to the performance of the underlying bonds (minus hedging costs).
  • If he wants currency exposure, an unhedged investment gives him exposure to both the underlying bonds and the currency fluctuations, which tend to overshadow the performance of the bonds themselves.

Putting it together

International bond prices respond to factors that have relatively low and varied correlations with Canadian bonds.

To further diversify, our research finds investments in international bonds should be hedged. Otherwise, investors will be exposed to more volatile currency risks.

History suggests reallocating a portion of an investor’s domestic bond exposure to international bonds can help lower portfolio volatility.

An investor should weigh trade-offs among several factors, including the potential to reduce portfolio volatility, desire to gain exposure to the largest global asset class and the costs of implementation, as well as the investor’s views on the future of the Canadian dollar.

Read: How to manage a bond portfolio

And although there’s no optimal allocation for all portfolios, investors should seek to balance the diversification benefits against costs and other practical considerations. So, a reasonable starting place may be to mirror a portfolio’s exposure to non-Canadian equities.

Atul Tiwari is managing director of Vanguard Investments Canada.

Originally published in Advisor's Edge Report

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