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By Christine Benz | 10-17-2013 03:00 PM

Noncore Bonds: What to Know Before Investing

Noncore bonds can play relevant roles in investors' portfolios, but they should consider potential political risk, currency risk, credit risk and equity correlation, says Vanguard's Chris Philips.

Christine Benz: Hi. I’m Christine Benz for Morningstar.com. I recently visited Vanguard, where I sat down with Chris Philips, a senior analyst in the firm's investment strategy group. We discussed some of the noncore bond types that investors have been flocking to over the past several years.

Chris, thank you so much for being here.

Chris Philips: Absolutely. Thanks for having me.

Benz: When we look at fund flows, and we have a lot of data at Morningstar that looks at investor behavior and what they’ve been buying, we’ve been seeing that within the fixed-income space, investors have a very strong appetite for high-income producers. They’ve been looking to some of these noncore categories. I’d like to cycle through some of them. 

Global fixed income is one; we haven’t seen flows there be quite as robust. But Vanguard recently did add global fixed-income exposure to a number of its products, including the Target Retirement lineup. I’d like to discuss the pros and cons of that asset class and what role you see it playing in investors’ portfolios.

Philips: It's actually the largest asset class that’s out there. Some investors might not realize that, but when you think about this four primary asset classes, U.S. and non-U.S. bonds, U.S. and non-U.S. stocks, non-U.S. bonds is the largest asset class out there. So we think it is absolutely relevant to talk about it. The biggest question is what type of exposure do you get and how do you go about implementing it in your portfolio? When we actually look at investors' portfolios, most investors have much less exposure to non-U.S. bonds than they have to U.S. bonds, and there are various reasons why that could be a good thing. But what we also know is that most investors will use international fixed income the way they use international equities. By that I mean they actually have currency exposure in their portfolio.

Benz: They buy an unhedged bond fund.

Philips: Exactly, and that tends to be the easiest, most direct way of doing it because you don't have to worry about the hedging cost or the potential operational challenges of hedging in the portfolio. But what it does do is it leads to perhaps some unintended consequences when you think of diversification. When we think about the role of bonds in a portfolio, we view them as a vehicle to help diversify the risky assets that you already have. Now, whether that's stocks-only, whether it’s stocks, real estate, other types of investments that you have, we view fixed income as the ballast to all that volatility.

Currency and foreign exchange rates tend to be a lot more volatile than bonds, less volatile than equities, and somewhere in the middle between those two. The challenge, though, is that by having that exposure to foreign currency in your fixed-income portfolio, you now have something that acts more like stocks than bonds, and it may not actually be a diversifier that you intend it to be.

Benz: Vanguard's choice in terms of implementing foreign bonds into the lineup was actually to use fully hedged funds, and you incorporated them across the target-date lineup. About how much of the fixed-income weighting within those target-date funds is foreign fixed income?

Philips: We targeted 20% of the fixed-income exposure to be in non-U.S. bonds, and that is consistent whether you are in the 2050 fund or in the income fund. It's the fixed income to equity exposure that changes. But within equities we have a constant 30% exposure to international equities, and within bonds we have a constant 20% exposure to international bonds.

Benz: How did you arrive at that 20%?

Philips: That's actually an interesting question, and I would love to be able to sit here and say there is a mathematical quantitative reason for that. There is some analysis that goes into driving that. But the reality is, if you look at the numbers, the numbers, whether you use pure market cap--market cap would, say, be around 60%--if you use a mean-variance-type framework, it might actually say 90% to 100% should actually be in foreign bonds. But then we have the reality that most investors might not tolerate that much foreign fixed-income exposure. And having U.S. fixed-income exposure when most of your liabilities, if not all of them, are going to be in dollars--they are going to be linked to U.S. inflation, U.S. interest rates--there has to be some stepping back from that significant allocation. We start off by saying that we want more than none. We felt like 30% to 40% was probably a little aggressive for the first-time move, and so essentially we landed on 20% as a great balance between opportunity for diversification, cost of implementation, and the reality of a very significant home bias for most U.S. investors.

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