Diversify Your Bond Portfolio with Foreign Accented Funds

The recent series of fed funds rate cuts by the Federal Reserve was designed to help stabilize uncertain and illiquid bond markets and keep the economy from slipping into recession, but it also impacted many investors' more secure income options. That's because yields on cashlike investments dropped dramatically in response to the rate cuts. And while the total returns on U.S. Treasury bonds have been very strong over the past year, as these bonds benefited from a flight to quality, the yields now on offer in this market are meager. In fact, as of July 7, 2008, the five- and 10-year Treasury notes yielded roughly between 3.19% and 3.90%, respectively, not providing most investors with an attract income option, or indeed one keeping pace with current rates of inflation.

What, then, is an investor seeking income to do? One thought is to consider keeping a portion of your fixed-income portfolio (perhaps between 10% and 25%, depending on your risk tolerance) in either a global of foreign bond fund. This option not only can add useful return diversification, as foreign bond market performance will often not correlate with domestic fixed-income return movements, but given that foreign bond markets now account for more than half the size of the overall global bond markets, to ignore these funds is simply short-sighted.

In the world-bond category, for instance, funds hold sovereign debt issues, often fully or partly unhedged, and occasionally emerging-markets bonds, so the category holds a reasonably low correlation coefficient (often less than 0.60, where 1.0 indicates perfect correlation and no risk reduction potential to -1.0, indicating perfect negative correlation, and maximum risk reduction) with most other taxable bond categories, and a very low return correlation to U.S. equities. These effects result from a number of factors, including national variability in business and interest-rate cycles, variation in inflation expectations, and currency fluctuations. And while some argue that a convergence of many aspects of local economies, one to another, will diminish this diversification potential, we think valuable diversification should remain.

The most recent period illustrates this well, as the European Central Bank's recent hike of its short-term interest rate, to 4.25%, contrasts sharply with the Fed's current holding pattern at 2%, illustrating the subprime-mortgage meltdown and liquidity crisis' outsized impact on the U.S. economy. Moreover, while both the Fed and the ECB are inflation fighters, the Fed's added mandate of supporting economic growth, and a possible new mandate of managing asset price bubbles, should continue to allow for variations in central banking policy that would support the thesis of continued interest-rate diversification.

Two ways investors can cautiously express a global theme for part of their fixed-income portfolio would be through a well diversified world-bond category fund, such as Morningstar Fund Analyst Pick  Loomis Sayles Global Bond (LSGLX), or through an intermediate-term bond fund, like  Julius Baer Total Return Bond  that takes foreign bond positions. In both these cases, investors should be aware of the fact that the funds take on some credit, interest-rate, and currency risks, which can add to the volatility of their returns, but these two options don't make outsized bets.

If we take the  Vanguard Total Bond Market Index (VBMFX), which tracks the Lehman Brothers Aggregate Bond Index (commonly thought of as a proxy for the broad, investment-grade U.S. bond market) and look at the typical return correlation for the 10-year period ended June 30, we discover these funds do offer significant diversification from U.S. markets. Loomis Sayles Global Bond, for instance, holds a 0.49 correlation to the Aggregate's returns, and Julius Baer Total Return Bond a 0.83 correlation. In both cases these funds' respective 12-month yields of 6.27% and 5.27% outweigh the 4.91% yield available from the Vanguard fund. And from a long-term total return perspective, both funds outperform this domestically focused index fund.

Over the long run, we think adding modest global exposure to one's portfolio can boost overall income and total return, possibly supporting it in times when good fixed-income opportunities are harder to come by through domestic markets. Taking on a more global view has paid off handsomely for equity investors over time, and indeed many managers point to the fact that some of the best firms in any given industry now reside outside the U.S. Along similar lines, we think it's important for bond investors to look more broadly than they have in the past, as opportunity can now be found in many corners of the globe.