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Guest Post Wednesday: MossySF on International Bonds

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For this Guest Post Wednesday, frequent commenter MossySF writes about international bonds. I have to admit that because of my age and risk tolerance, I haven't put too much thought into bonds - much less international bonds. This is another reason why this guest post Wednesday, can be helpful. It fills the gaps of areas that I wouldn't have otherwise thought about. Enough of the intro, here's the article:

If you've read up before about asset allocation, one topic often mentioned is international exposure. The conventional wisdom says anywhere from 15% to 50% of your equities should be international. But what about bonds? If you are at that stage of life where you need the lower volatility bonds give your portfolio, do you also need to diversify bonds against domestic inflation/currency/interest rate risks? A small minority of asset allocation advice say yes but the remainder usually stay silent on this topic. With my interest perked up about this subject, I decided to explore the international bond investments available. My first stop was of course index funds. As a firm believer in keeping expenses down, I checked out Vanguard to see if they had anything in this category. No dice. Fidelity? Nope. T.Rowe Price? Nada. What about ETFs? The only company even offering bond ETFs of any kind is Barclay iShares (although Vanguard will have Bond ETFs soon) and they're all domestic.With the index fund avenue closed, I next looked at actively managed funds. After a few unproductive searches, I found list of foreign bond funds at Yahoo. Unfortunately, the options listed turned out rather depressing. You either pay load + high expenses or need an extremely high dollar amount to buy in. Here's a sampling of the funds I encountered:

Fund Yield Load ER Min Invest
------------------------------------- ----- ----- ----- ----------
Alliance Bernstein Global Strat Inc I 3.69% 0% 1.41% 10,000,000
Alliance Bernstein Global Gov Inc A 5.25% 4.25% 1,34% 2,500
Delaware Pooled Global Fixed-Income 4.27% 0% 0.60% 1,000,000
GMO International Bond III 5.45% 0% 0.39% 10,000,000
Henderson Worldwide Income A 5.69% 4.75% 1.55% 500
Merk Hard Currency Inv 2.55% 0% 1.55% 2,500
Oppenheimer International Bond A 3.58% 4.75% 1.22% 1,000
Templeton Global Bond A 5.65% 4.25% 1.28% 1,000
Templeton Global Bond Adv 5.92% 0% 0.78% 100,000

At this point, I had given up on the idea of picking up the international bond asset class. Maybe this is why people rarely talk about it? Then I remembered a blog post at 1stMillionAt33 about tax-free closed-end bond funds. Perhaps closed-end funds is the place to look. Following the steps in the blog, I went to etfconnect.com and searched for global fixed income -- 40 funds found. 40 is a rather big number to decide on so I arbitrarily applied the following filters.

  • Avoid funds trading at high premiums. Closed-end funds can trade higher or lower than the daily calculated NAV price due to market irrationality.
  • Avoid funds with high expenses. ETFconnect shows the yields after expenses and in theory, you get the same return whether it's 10%+3% expenses or 8%+1% expenses. However, you are taking extra risk to pay for higher returns just to cover expenses.
  • Avoid funds with > 20% US fixed equities. I like to keep my asset class picks as pure as possible for easier allocation calculations. Plus with so many options for US bonds, it doesn't make sense to to combine foreign+US together in one investment.

After filtering the results, I ended up with the following options:

Fund Yield ER Prem Region Duration
------------------------------------- ----- ----- ------- --------- --------
CMK - Colonial Intermarket Income 6.44% 1.11% -9.01% Developed Medium-Long
JGG - Nuveen Global Gov Enh Inc 8.07% 1.09% 4.86% Developed Long
TEI - Templton Emerg Mkt Income 6.99% 1.22% -5.54% Emerging Medium
MSD - Morgan Stanley Emerg Mkt Debt 5.92% 1.34% -7.59% Emerging Medium-Long
ESD - Western Asset Emerg Mkt Debt 6.86% 1.02% -14.29% Emerging Medium-Long
EDF - Western Asset Emerg Mkt Debt II 7.97% 1.28% -12.06% Emerging Long
* as of 4/7/07

At this point, it was a shrug of the shoulders moment. I have no idea whether 20% Russian + 15% Mexico is better than 15% Russia + 20% Mexico. So again I looked at expenses. ESD is the definite winner in the Emerging Market bond segment while CMK and JGG are relatively equal for Developed Markets. JGG has a higher yield but with instruments with longer maturity dates also has more risk. In the end, I picked all three in roughly equal percentages and I am now periodically adding to these positions. It'll may take 5 years before I reach my target goal of 50% domestic, 35% developed intl, 15% emerging market as I only have my IRA/Roth IRA money (tax-sheltered brokerage) to devote to this. I hope by that time, Vanguard or iShares will have low-cost funds or ETFs to cover this market segment.

Thanks once again, MossySF.  If you want to read more by him, leave some comments and maybe he'll write again.

Posted on April 11, 2007.

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10 Responses to “Guest Post Wednesday: MossySF on International Bonds”

  1. Dong says:

    When it comes to international equity funds, I much more willing to pay a little extra for a actively managed fund just because the foreign markets tend be so much more opaque, and the the traditional indexes less than representative. That goes doubly with bond funds I imagine. I’m with LazyMan given my age and risk tolerance, I haven’t really looked at bonds other than some tax exempt muni funds as a small portion of my portfolio.

  2. pfodyssey says:

    I think this topic is a good one and agree that it is probably an area that is not thought about very much. Although expenses are an important component of the overall picture, finding a fund with a proven track record is my primary interest.

    I also quickly noticed that T Rowe Price was mentioned as not having any international bond funds. This is absolutely not the case. I know because I have some of my portfolio invested in them. The fund symbol is PREMX (emerging markets bond).

    PREMX Fund Objective:
    The investment seeks to provide high income and capital appreciation. The fund normally invests at least 80% of assets in government or corporate debt securities of emerging markets issuers. The holdings may include the lowest-rated bonds, including those in default. It is nondiversified.

    The expense ratio is 1.03%

    Calendar Year Total Returns:
    1997 16.83%
    1998 -23.09%
    1999 22.97%
    2000 15.20%
    2001 9.35%
    2002 9.52%
    2003 26.05%
    2004 14.83%
    2005 17.26%
    2006 11.43%

    Although I understand where Dong is coming from in terms of his comment about bonds, I would ask that he reconsider as some of them can still have very strong returns (see above) and also provide some “zig” when the market “zags” to reduce your volatility / equity exposure.

  3. MossySF says:

    Thanks pfodyssey for the note. Not sure how I missed the T.Rowe Price search but now I see 2 options available for the individual investor:

    RPIBX – International Bonds
    PREMX – Emerging Market Bonds

    I’m surprised on though how low the yield (3.36%) is for RPIBX. That probably means they’re overweighted in Japan where rates are way lower than the U.S. and Europe.

    Dong, the wisdom being pushed a decade ago was index funds are great for large cap but an active manager can find the bargains in midcap and smallcap. And now when we look at performance in retrospect, small cap indexes have outperform active small cap managers by even a greater margin than in the large cap sector. I suspect it’s the same for international — the value of extra knowledge is probably beat every time by expenses turnover market timing.

  4. MossySF says:

    pfodyssey, I re-read my post and I forgot I was looking for International INDEX Bond Funds when I did the T.Rowe Price nada mention. So that’s still correct. However, those two funds would have been listed in actively managed list had I found them. I probably still wouldn’t have picked the developed market fund at 3.35% yield — not only the rate is low but it’s a a high risk of losing principal since the logical direction for low rates is to go up. The T.Rowe Price Emerging Market fund is competitive although the Western Asset closed-end funds look to be slightly better in that category due to being able to buy at a discount.

  5. Sun says:

    I like the idea of diversification even in the bond area, but is paying 1 % ER on bond investment a little high? I am not so sure since I haven’t really looked for any. Also investing in foreign bonds doesn’t necessarily mean “low volatility.” In fact, many of the emerging market bonds are quite volatile. Of course, you will be rewarded by taking a greater risk.

  6. MossySF says:

    1% is certainly higher than I’d like to pay. Hell, 0.10% is higher than I’d like to pay — gimme 0% expense ratio! But some asset classes just aren’t available in low-expense options for the average investor. (GMIBX charges .39% — you just need $10M to open an account with them.)

    I’m not sure who you’re responding to with the low volatility question. I wrote about adding bonds to decrease the volatility of an all equities portfolio. And certainly any specific country/region bond might be more volatile than another region, combining multiple regions together could decrease volatility if those regions’ bond investments aren’t completely correlated.

  7. […] Man and Money has a guest post on investing in international bonds. If you are considering adding about foreign bonds, developed or emerging markets, to your […]

  8. […] Guest Post Wednesday: MossySF on International Bonds (tags: international bonds) […]

  9. Mark says:

    Hi all. Interesting subject. I wanted to make a few points. Bonds are designed to give your portfolio stability, income and lowered risk in the event of a stock market rout, and letting you take advantage of rebalancing by selling appreciated assets and buying lagging ones, which often results in a few extra basis points of return.

    Does anyone think that high yield emerging market (EMG) bonds give stability or lowered risk? The yield spread between US Treasury securities and EMG bonds is at its lowest in years. Does anyone believe that the trend will continue to the point that EMG debt has a lower yield than Treasuries? Right now, the risk premium on EMG debt is at its lowest in years. Is the risk lower?

    Market-timers may be attracted by strong recent returns in EMG debt issues, but those returns have been enjoyed already. Let’s not forget that it was the tiny risk premiums on EMG debt over Treasuries that lured Long Term Capital Management, causing it to explode in 1998 when yields moved the wrong direction.

    A yield of 3.36% with an ER of 1%? So fully 1/3 of the yield will be eaten by expenses? Bonds have posted capital gains due to declining interest rates. This cannot continue forever.

    Bonds are for stability. If you need exposure to foreign currencies, do it with equities.

  10. MossySF says:

    My two main desires for international bonds:

    1) Currency diversification — I don’t have a good feeling about the long-term prospects of the U.S. dollar. To be honest, the entire fiscal approach of the people here and the government completely suck. Having a lot of domestic bonds for income doesn’t help much if the interest is worth less and less every payout. So I’d rather have money being paid in dollars and euros and yen and rmb and so on. Combine it together into one big melting pot so I take my income in global dollars.

    2) More uncorrelated classes lead to more stable returns. Just because the bond market is already more stable than stocks doesn’t mean I can’t aim for even better. I’m sure sometimes emerging bond markets will perform badly. And sometimes intl developed bond markets will crap out. And sometimes the U.S. bond markets will be unpredictable. But combine it together and I should get an even less volatile bond market than any one region. The exact conditions of any of the markets, I only have a passing interest in as I’m just slowly adding to all regions over the next few years as I continually invest money.

    Now, I certainly want much lower expense international options. But I’m not interested in waiting around so paying 1% ER now means instead of jumping directly into my desired 50-35-15 split, I start off slow at 80-15-5 or 90-7-3 where I get a bit of volatility reduction w/o totally killing the yields after expenses.

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