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Making your bond-fund portfolio less risky requires doing something that can feel like living dangerously: investing abroad.
If you’re like most people, you may have put too much of your money in bond funds invested in your home market and so failed to spread your bets around.
“People are used to thinking about diversification in their stock portfolio, and they understand how that works to control the risk,” said Rob Waldner, chief strategist for fixed income at Invesco. “You need to do that with your fixed income, too.”
Bond diversification matters all the more when traditional income producers like U.S. Treasuries are paying measly rates, he said.
With the pandemic beginning to wane, bond yields are ticking up — the 10-year U.S. Treasury, a benchmark bond, was paying 1.7 percent in early April, compared with less than 1 percent in January. But rates are likely to remain relatively low by long-term standards.
Bonds come in a variety as rich — and sometimes baffling — as the screw-and-fastener aisle at Home Depot.
A well-diversified portfolio might include mutual funds or exchange-traded funds that buy bonds issued by the United States and foreign governments, and large U.S. and foreign companies, as well as ones backed by mortgages, auto loans or credit-card receivables in the United States. (Pools of these financial assets are securitized, and rights to payments from the pools become mortgage-backed and asset-backed bonds.)
“Home bias” is the financial term for people’s tendency to over-invest in their home market and shy from other places. Investment experts say it’s pervasive.
“It’s something we observe in every country,” said Roger Aliaga-Diaz, global head of portfolio construction at Vanguard.
Do-it-yourself investors typically keep about 85 percent of their bond investments in their home market, Mr. Aliaga-Diaz said.
In contrast, people who buy into Vanguard’s U.S. target-date retirement funds (which handle investment allocation for their shareholders) have about 70 percent of the bond portion of their money invested at home and 30 percent abroad, he said.
Vanguard’s research has found that international bonds reduce portfolios’ ups and downs without hurting the total return. Internationally diversifying can provide access to securities from more than 40 countries.
“This broad exposure is important, as the factors that drive international bond prices are relatively uncorrelated to those that drive prices in the U.S.,” the report said. Lately, for example, South Korea’s 10-year government bond is yielding 2 percent, while Mexico’s is yielding nearly 7 percent.
The international bond slice of Vanguard’s target-date funds is invested in the Vanguard Total International Bond Index Fund, which owns mainly developed-world bonds. Like many international bond funds, it uses hedging to protect its shareholders against the return volatility that currency fluctuations can cause.
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Jean Boivin, head of the BlackRock Investment Institute, said his outfit’s research suggests that investors may want to be bold in their foreign bond forays and look beyond developed markets.
“You need to think about emerging-market bonds and, in particular, Asia ex-Japan,” he said.
In the past, investors could view the U.S. bond market as a proxy for the world, partly because U.S. companies often had sprawling international operations, Mr. Boivin said. But there is enormous global diversity today. Foreign markets, especially China, have risen so much that this approach doesn’t work as well.
Someone’s precise stake in emerging-market bonds, or any specific bond subclass, will be determined by that person’s risk tolerance and other assets. BlackRock’s broadly diversified Total Return Fund might provide a starting point for considering reasonable ranges. It recently allocated about 8.6 percent of its assets to emerging markets.
The Fidelity Total Bond Fund, another broad offering, lately had a 16 percent stake in higher-yielding, riskier kinds of domestic and foreign debt.
“Historically, we’ve owned from 8 to 18 percent in the higher-yielding sectors,” said Celso Munoz, one of the fund’s managers. “It’s appropriate for most people to have exposure to the broader fixed-income world, which would include high yield, emerging markets and bank loans.”
People may tend to shun international bonds partly because stocks overshadow bonds in the popular media, said Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research.
“Every day somebody is talking about the S&P 500 or the Dow,” she said. “People don’t talk like that about Bloomberg Barclays U.S. Aggregate Bond Index,” a leading bond index, and relatively few people plunge even deeper into the fixed-income universe.
To decide how you might better diversify your bond funds, it helps to reflect on why you own them, said Tad Rivelle, chief investment officer for fixed income at TCW.
“The existential question is do you think of fixed income as a safe asset that enables you to take risk elsewhere,” he said, “or do you expect your bonds to pull their own weight, and so you’re OK with them going down in a market panic?”
People in the former group might favor more traditional fixed-income categories, like Treasuries and investment-grade corporate and mortgage bonds, while those in the latter might also opt for high-yield bonds or a greater variety of securitized fare, he said. TCW’s MetWest Total Return Bond Fund might work for the first group, and its MetWest Flexible Income Fund for the second.
A puzzle for all bond-fund investors is how the end of the Covid-19 pandemic might affect interest rates.
Rates usually rise when the economy grows, as it’s expected to do as the world emerges from the pandemic. As that happens, inflation may rise, which could stifle a long bull market in bonds. Bond prices rise as interest rates fall.
Yet renewed inflation has been erroneously predicted before, and Jerome Powell, the chair of the Federal Reserve, has made clear that the bank isn’t rushing to raise the short-term rates it controls.
For investors who are counting on their bond funds for income, continued low rates could create a temptation to court risk.
A more patient approach is prudent, said Mary Ellen Stanek, chief investment officer for Baird Advisors, which oversees the Baird Funds.
“You don’t own bonds for excitement and drama,” she said. “You own them for predictability and lower volatility.”
Ms. Jones of Schwab warned, too, against seeking excessive risk. She suggested investors instead rethink how they take cash from their portfolios.
“In a year when your stocks are up 20 percent and your bonds are up 2, you may want to pull out some of those capital gains and put them in your cash bucket,” she said. “Say you’re looking to generate 6 percent overall, and you’ve made 20 percent in stocks. If you have excess above your plan, you can look at that as potential income.”
No matter what path investors choose, they should always pay close attention to the costs of funds and E.T.F.s, said Jennifer Ellison, a financial adviser at Bingham, Osborn & Scarborough in San Francisco.
“Costs are really important, especially with yields where they are,” since those costs will eat up much of that scant yield, she said. “If you’re a retail investor and you’re buying a loaded bond fund, you’re giving all your yield away up front.”
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