Most discussions of asset allocation suggest that you keep a portion of your stock holdings in international funds as opposed to U.S. funds. What you don’t hear very often is the suggestion to include international bonds.
But would it be a good idea to do so?
It depends on your circumstances, but in most cases, I’d say no. International bonds aren’t worth owning due to:
- Higher expenses, and
- Currency risk.
Higher Expense Ratios
You can easily find U.S. bond ETFs and funds with expense ratios of 0.15% or less per year. And (depending on your brokerage firm) you won’t even have to pay a commission to buy them.
In contrast, for international bond ETFs, expense ratios in the range of 0.35-0.50% are typical. And in most cases, you’ll have to pay commissions on each transaction.
Or, if you don’t want to pay commissions for your international bond holdings, you can go with an open-end mutual fund. As far as I can tell though, there aren’t any open-end international bond funds with expense ratios of less than 0.80%. (If you know of one, please mention it in the comments.)
In other words, international bonds come at a cost of ~0.50% more than you would pay for a decent U.S. bond index fund.
In contrast, the difference in expense ratios between U.S. stock funds and international stock funds is much smaller: often less than 0.20%.
Takeaway: International diversification for your bonds is significantly more expensive than international diversification for your stocks.
International bonds (and international stocks) carry currency risk. Currency risk is the risk that the currency in which the investment is denominated will decrease in value relative to the dollar, thereby decreasing the investment’s value.
Example: Imagine that you own Russian bonds with a 5% yield. Over the life of the bonds, if the Russian ruble decreases in value relative to the dollar at a rate of 3% per year, your return will only be (roughly) 2%. Of course, the opposite could happen too: the ruble could increase in value relative to the dollar, thereby increasing your returns.
But we don’t know which will happen. That’s why we call it currency risk.
Why Do You Own Bonds?
Whether or not it makes sense to pay higher expenses and take on currency risk depends on your goals.
For many U.S. investors, the purpose of owning bonds is to earn relatively predictable returns. If that’s why you own bonds, I’d stick with U.S. bonds (TIPS, in many cases). Because international bonds come with currency risk, their returns (as measured in U.S. dollars) are less predictable.
On the other hand, if you’re an “asset class junkie” whose goal is simply to add one more (hopefully) uncorrelated asset class to your portfolio, then an international bond fund may make sense. But even then, because of their high expense ratios and relatively low long-term expected returns, international bonds aren’t exactly optimal.
For the most part, the only scenario in which it makes a lot of sense to own bonds denominated in a foreign currency is when you have expenses denominated in that currency. For example, if you’re saving for a vacation villa in Spain, you may want to do so with Euro-denominated bonds.