How Much Foreign-Bond Exposure Do Retirees Need?

The European debt crisis took a toll on many world-bond funds in 2011, with the average fund in the category gaining less than half as much as the Barclays Aggregate Bond Index. (Granted, most domestically focused bond funds also underperformed the BarCap's 7.8% return in 2011.) The typical fund in this group has more than half of its portfolio in European bonds, so few emerged from the recent crisis in the eurozone unscathed. The average world-bond fund lost about 1.2% in 2011's third quarter, and unhedged funds that emphasized European bonds fared much worse than that. (Some world-bond funds hedge their foreign-currency exposure, meaning they use currency futures to negate foreign-currency effects on their portfolios' results; their returns capture their bonds' performance, not currency fluctuations.)

The recent travails of world- and emerging-markets bond funds have me wondering how big a role foreign bonds and bond funds should play in a portfolio, particularly for preretirees and retirees who are steering ever-larger sums to fixed-income securities.

Setting Some Baselines
As with most asset-allocation decisions, setting a strategic, long-term allocation to foreign bonds can help you avoid being whipped around by market sentiment. The dollar's recent moves provide a strong case in point. For example, it climbed relative to the euro during the European debt crisis. But a little more than a year ago, having watched the dollar slide versus major foreign currencies for the better part of a decade, many market watchers were arguing that the dollar was in an inexorable state of decline and that a big non-dollar-denominated bond position was a must for U.S. investors.

So how do you go about setting a long-term allocation? As with most asset-allocation questions, the answer depends heavily on where you are in your investing life cycle and what you're trying to achieve.

Younger investors who are in growth mode might look to the foreign-currency exposure that foreign bonds provide as yet another source of diversification, just as someone would diversify across asset classes and investment styles.

But for most investors, especially those in or nearing retirement, the bond sleeve of their portfolios is there to provide stability more than it is for diversification or return-generating potential. And for that reason, the volatility of unhedged foreign bonds may be a wild card they just don't need--at least not in large doses. During the past decade, the standard deviation of world-bond funds is 7, versus 4.4 for intermediate-term bond funds, the latter of which tend to put most of their assets in U.S. bonds.

The allocations in Morningstar's Lifetime Allocation Indexes, which are based on the asset-allocation guidance of Ibbotson Associates, bear out the notion that foreign-bond (and stock) allocations should step down as one gets closer to retirement. The allocations geared toward younger investors--those under age 40 or 45--stake as much as 20% or 25% of their relatively slender fixed-income sleeves in non-U.S. bonds. But the non-U.S. portion of the fixed-income portfolios taper off dramatically for investors nearing or in their retirement years. The non-U.S. bond allocations for those who retired in 2010, for example, consume roughly 10% of the total fixed-income portfolio and dip even lower for those who retired in 2000.

Foreign-Bond Types
Although those allocations are a useful starting point when determining an appropriate allocation to foreign bonds, it's also worth noting that there are multiple ways to invest in foreign bonds, some of them risky, some of them less so.

The world-bond category showcases the broad range of approaches. Hedging policy is a key differentiator, with hedged portfolios typically courting less volatility than unhedged funds. Funds also differ in the types of bonds they'll buy: Some focus exclusively on government-issued debt, while others also own bonds issued by corporations.

Market maturity is another swing factor that affects a fund's volatility profile: Some offerings focus on developed-markets bonds and may also throw some U.S. holdings into the mix, while others include a bigger dose of emerging-markets names. Finally, world-bond funds employ varying approaches to interest-rate sensitivity, from relatively short (such as  DFA Five-Year Global Fixed-Income (DFGBX)) to long (such as  SPDR DB International Government Inflation-Protected Bond (WIP)).

Thus, the type of investment you use should also factor into the decision about whether to hold more or less of it. A retired investor who sticks with a more conservative foreign-bond investment--for example, a hedged fund that focuses on shorter-term foreign-government bonds--might reasonably stake more in such an offering than another retired individual who ventures into an unhedged international-bond investment that's heavy on emerging-markets debt.

Other Swing Factors
What you already have in your portfolio should be an additional consideration when deciding how much to stake in foreign bonds. A starting point should be to consider how much foreign-bond exposure you might already have via intermediate-term bond funds such as  PIMCO Total Return (PTTAX) or  Loomis Sayles Bond (LSBRX). Also consider your foreign-stock holdings, most of which bring your portfolio substantial foreign-currency exposure. If you have a fairly high weighting in foreign stocks overall, bear in mind that layering on a foreign-bond fund will further subject your portfolio to currency fluctuations.

A version of this article appeared Nov. 15, 2011.

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