(July 2012) As we discuss in our article “World Bond Funds: Do you Know the Risks” you are exposed to three primary types of risks when investing in world bond funds: Interest Rate, Credit, and Currency Risks. However, while there are additional risks associated with investing in world bond funds vs. domestic bond funds, this does not necessarily mean that there is more TOTAL risk.
By spreading their investments out across bonds in multiple countries whose currencies are different from the US Dollar, world bond funds can also provide additional diversification that is not available from domestic bond funds.
So how risky are world bond funds and how much diversification benefit do they provide?
Over the last 3 Years World Bond Funds have returned 7.3% per year on average. During that time over 65% of World Bond Funds averaged between 0.2% and 14.4% per year. Over 10 years, the average annual total return was 6.5%. Over 65% of funds during that time had an average annual return between -0.5% and 13.5%.
How does this compare against US intermediate bond funds?
Over the last 3 years Intermediate Bond Funds have returned on average 8.1%. Over 65% of intermediate term bond funds had a 3 year annual total return between 5.0% to 12.2%. Over 10 years, the average annual total return was 5.23%. Over 65% of the funds had a return of between 0.93% and 9.53% during that time.
The numbers indicate that world bond funds have historically been more volatile than Intermediate Bond Funds, and had lower average returns.
However, volatility looked at in isolation can be misleading.
Sometimes, adding a volatile asset class can actually reduce overall portfolio volatility. However, for this to be true, there is one major requirement: The asset class must have returns that are uncorrelated to the other asset classes held in the portfolio. This is true for world bonds. A study by Nuveen indicates that world bonds have a moderate correlation with US bonds and a low correlation with US Stocks.
Image From Morningstar Article, “Good Bye Pete. Hello World.”
Because of the diversification benefits which they can provide, Nuveen investments recommends putting up to 25% of a portfolio in World Bond funds. However, they recommend investing specifically in world bond funds where currency risk is not hedged. In short, they believe the currency risk is important to achieve diversification.
On the other hand, a recent article by Vanguard, “Global Fixed Income: Considerations For US Investors”, states:
We’ve shown that on average, the volatility of currencies can overwhelm any diversification benefit that international bonds may bring to a diversified portfolio.
So, while both Nuveen and Vanguard agree that World bond Funds should be part of your portfolio, they have opposing views on how it should be done.
What is the individual investor to do?
Two leaders in money management cannot agree on the type of world bond fund one should hold. As there is a chance that implementing this could backfire and increase volatility if not done correctly, I would not recommend World Bond Funds for for most investors.