Matt Peden, Chief Investment Officer for GuideStone Capital Management®, recently shared his thoughts surrounding the primary advantages of foreign bonds and how they may be able of benefit — particularly as the bond landscape continues to change.
As you look across the current investment landscape, is investing in foreign bonds a good idea right now? Why?
GuideStone® strongly believes that incorporating actively managed foreign bonds into a diversified portfolio is a very good idea and may provide several key advantages for investors, including:
Increasing the Investable Opportunity Set
Many investors have adopted global equities into their diversified portfolios but have not done so with bonds. This may be because investors look to be more conservative within their bond allocation. However, it should be known that the global bond market has undergone considerable growth and maturation over the past 15 years. In fact, the U.S. now accounts for only 38% of the total global fixed income universe.
The bond market today provides investors broad opportunities across regions, countries, sectors, industries and underlying securities. Expectations are for this progression to continue — with the goal of aiming to provide even more opportunities into the future.
By utilizing a U.S. core bond fund as their only fixed income holding, investors potentially miss more than half of the investment opportunities afforded by the global bond market. Going global allows portfolio managers to take advantage of a full playing field when looking for investment ideas and market dislocations in their efforts to generate alpha and manage risks.
The maturation of the global bond market provides return patterns to be derived across sectors and industries within both the developed and emerging markets. Within the developed markets, there is sovereign debt, mortgage backed securities and securitized bonds — in addition to corporate debt across the maturity and credit continuum.
Investing in emerging market debt also provides an abundant universe for portfolio managers. Government debt, corporate debt and inflation-linked notes provide the majority of trading within the emerging markets. There is now even issuance within frontier markets (markets too small to be considered emerging markets).
Alpha can be gained through security selection, sector rotation, duration/yield curve positioning and currency. These alpha sources, unlike a U.S. core bond portfolio, can be applied across most regions, countries and non-U.S. economic cycles. Often due to idiosyncratic opportunities in the non-U.S. universe, analysis indicates that there is a wide dispersion of returns across global markets, and, more importantly, correlations across returns of different markets indicate considerable diversification benefits to both fixed income and equity allocations.
Investors often think of diversification in return patterns when constructing portfolios, but it is just as important to diversify risks. Investing in foreign bonds further diversifies the risks that an investor is taking compared to a U.S. core bond fund.
The table below illustrates how an investor can spread his or her risk by investing in sectors across regions and countries. This allows a portfolio to be less dependent on certain market situations and/or economic environments.
While some global or foreign bond funds have higher volatility profiles compared to U.S. core bond funds, their return patterns provide potential diversification benefits that may help reduce risk when incorporated within a well-diversified portfolio.
Diversifying Sources of Income
Global bonds, especially emerging market debt and high yield, have historically provided higher levels of income than U.S. investment grade bonds. Moreover, exposure to currencies other than the U.S. dollar may provide return and diversification benefits to a portfolio.
Can you tell us a recent example of international bonds proving to be a sound investment?
We’ve recently seen exposure to emerging market debt add value to the portfolio in several ways:
- Mexican government and credit bonds were a contributor to performance in the first quarter, seeing some relief from the NAFTA overhang.
- Select emerging market corporate issuers, such as state-owned oil companies in Latin America and financials in the United Kingdom, offered good carry potential and benefit from improving sovereign fundamentals.
- Russian government bonds, with yields above 7%, were supported by a positive growth outlook given the recovery in oil and gas prices from their lows in 2015.
- Brazilian government bonds were supported by an improving economy and declining inflation.
How do foreign government bonds fit into a typical portfolio?
Foreign bonds are used for both diversification and return enhancement purposes. Investors should strongly consider allocating a portion of their existing U.S. core bond portfolio to non-U.S. bonds depending upon their risk tolerance. A more conservative investor may invest up to 20% of their bond allocation to foreign bonds, while a more aggressive allocation may range up to 50%.
Given the vastness of the investable universe and sophistication level needed to construct global bond portfolios, it would seem reasonable that most individuals invest in foreign bond funds versus individual bonds.
GuideStone Capital Management strongly believes in active management (versus passive management) when investing in foreign bonds. Investors should identify investment management firms that have the following characteristics:
- First and foremost, investment managers should have good macroeconomic skills across the globe, not just domestically. A keen understanding of local markets is essential to make yield curve and duration positions across countries.
- Next, a strong, but very deep, credit team is needed to cover both sovereign and corporate debt.
- Finally, currency knowledge is needed to position the portfolio in currencies expected to appreciate or the ability to hedge out of currencies expected to depreciate.
Learn more about how your clients can utilize our global bond strategy here.