Fixed-income investors may look to international markets to diversify their bond exchange traded fund portfolios, but people should be aware of the negative effects of foreign exchange fluctuations and keep in mind potential strategies to diminish the currency risks.
On the recent webcast (available on-demand), Diversifying Client Income with Currency Hedged Bonds, Abby Woodham, ETF Strategist at Deutsche Asset Management, argued that bond investors may be missing out when focusing on U.S. debt as international bonds make up almost 60% of assets in the investment-grade global bond market.
Matthew J. Krajna, Portfolio Manager at Nottingham Advisors, contended that investors should get out of their “home country bias” as the U.S. only makes up a portion of the global market.
In a survey of financial advisors on the webcast, 47% of respondents revealed that 10% of their fixed-income portfolio is made up of international debt, followed by 41% who had about up to 20% in foreign bonds.
Investors may be missing out on the potential diversification benefits as international bonds have shown a low correlation to U.S. stocks and bonds. Specifically, international Treasury bonds have exhibited a 0.87 correlation to the U.S. Aggregate Bond Index and -0.13 correlation to the S&P 500. International investment-grade bonds have also traded at a 0.67 correlation to the U.S. Aggregate Bond Index and a 0.32 correlation to the S&P 500.
International bonds can help investors diversify sources of interest rate risk. While U.S. rates have plunged to three-decade lows and recently hit all-time lows earlier this year, investors may turn to international bonds for positive returns.
“U.S. interest rates are on the rise. If global monetary policies continue to diverge, investors solely invested in domestic bonds may want to diversify their concentrated interest rate exposure,” Woodham said. “Additional quantitative easing (QE) in major financial markets such as Europe, Japan & United Kingdom is expected to keep interest rates low in those markets and support international bond credit markets.”
[related_stories]However, when investing in overseas markets, investors should consider the negative effects of currency risks on their investments as forex fluctuations have contributed to volatility. Investors, though, can manage the currency risks with a currency-hedged strategy, which is particularly of import with the U.S. dollar strengthening against foreign currencies.
“Currency hedging mitigates FX volatility and may help preserve cash flow when converted back to USD, potentially increasing the consistency of returns – fixed instead of variable income,” Woodham said. “In periods of U.S. dollar appreciation against other currencies, hedging can also add to an investor’s overall return compared to unhedged exposure.”
Sean Edkins, Director of ETF RVP for Deutsche Asset Management, outlined two recently launched currency-hedged international bond ETFs, the Deutsche X-trackers Barclays International Treasury Bond Hedged ETF (BATS: IGVT) and Deutsche X-trackers Barclays International Corporate Bond Hedged ETF (BATS: IFIX), as ways for investors to garner comprehensive international exposure and diversification potential while defending against currency risks.
The two international bond ETFs provide targeted market exposure to investment-grade global debt through an easy-to-use investment vehicle. Furthermore, investors will be able to diversify their portfolios and strengthen returns while minimizing volatility and losses to potentially generate improved risk-adjusted returns, along with offsetting exposure to fluctuations between the U.S. dollar and select foreign currencies.
Financial advisors who are interested in learning more about global fixed income opportunities can watch the webcast here on demand.