The role of an international bond fund in your portfolio
April 15, 2013
Diversifying your portfolio can include investments from around the world. Ken Volpert of Vanguard's Fixed Income Group and Sarah Houston of Vanguard Flagship Services® explain how investing in international bond funds can hedge against contrary movements in the domestic markets.
Amy Chain: I'm going to stay with you Ken. We have a couple of questions that I've seen come through on some of our bond funds. Let's take one from Nancy from Denver. Nancy says, "How should we add Vanguard's new [Total] International Bond Index Fund to our portfolio?" I think we should pause first and talk about what this new fund is. Ken, maybe you can take us through that and then, Sarah, maybe you can tell us how an investor might what to think about it.
Ken Volpert: Sure. So we have a couple of new funds that are coming out within the next couple of months. We have an international bond fund that is buying—just like we have total bond market that invests in the U.S. bond market, we have total international that invests in everything outside of the U.S. that's investment grade. So invests throughout Europe and Asia, that are investment grade governments, and corporate, and asset-backed, and then it hedges that back to the U.S. dollar. So it's a fully hedged, 100% hedged back to the U.S. dollar.
Amy Chain: That's an important phrase when you're talking about international bond investing.
Ken Volpert: Absolutely.
Amy Chain: Hedged or unhedged can really change the nature of a fund.
Ken Volpert: It's very different if you're unhedged. Unhedged—actually the volatility of the currency dominates the risk in an unhedged bond fund. And the bond market exposure is actually a pretty small portion of the volatility. But what we think makes sense—and we've got research that has been done on this at great depth—when you hedge it back it actually creates a bond market portfolio that is about comparable to the volatility of total bond market, but it's different drivers, it's different economies that are causing the market to do well, rates to go up or down, and so it's not perfectly correlated. And that lack of a perfect correlation, when combined, actually reduces volatility in the portfolio.
And as long as the expected return is about the same, if we could have lower volatility and about the same expected return, that improves the risk profile and the return profile of a fund.
And so that's why we're getting ready to launch this fund and we're including it in our Target Retirement Funds also. And then we have an emerging markets, U.S. dollar-denominated [Vanguard Emerging Markets Government Bond Index Fund], so it's buying U.S. dollar emerging market government bonds as another fund option that's available out there for investors.
Amy Chain: Tell me what that means. What would be the alternative to U.S. dollar emerging market bond funds?
Ken Volpert: There are emerging market bond funds that are buying local currency, basically buying the emerging market bonds in those emerging markets' own currencies. A lot of emerging market countries choose to go to the U.S. dollar market to actually list issues. And so those are the ones that we would be buying because we don't want currency risk in this fund for emerging markets. So it's a chance for investors to get exposure to improving fundamentals and what's going on in terms of natural resources that a lot of these emerging economies have available to them, and be able to do it without currency risk through our U.S. dollar funds.
Amy Chain: Sarah I would love it if you could talk about how these fit into a portfolio. And we've actually had a question come in from Allen in Connecticut who wants specifically to know about why you would invest in international versus domestic bonds. So you maybe you could fold that into your answer about how an investor might consider using this fund.
Sarah Houston: I think Ken really touched on already that for an average investor, that getting exposure to international bond funds really does help mitigate, even further the risk in a diversified portfolio, or the volatility, sorry, in a diversified portfolio. You know there's not an optimal allocation for every investor in terms of the research that Ken also alluded to. What we do know is that some exposure is better than none.
Ken also mentioned that we are adding it to our Target Retirement Funds when we do launch them, and it will actually make up about 20% of the fixed income allocation in those funds.
Amy Chain: Twenty percent of the fixed income allocation, not of the total portfolio.
Sarah Houston: That's exactly right. So I think that's probably a good starting point from which someone can think about and make their own decision. But I think if they are so inclined to add it, that's probably a good guideline to start from.
For more information about Vanguard funds, visit Funds, Stocks, & ETFs or call 877-662-7447, to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
A registration statement relating to the Vanguard Total International Bond Index Fund and Vanguard Emerging Markets Government Bond Index Fund has been filed with the Securities and Exchange Commission but has not yet become effective. These securities may not be sold nor may offers to buy be accepted prior to the time the registration statement becomes effective. This communication shall not constitute an offer to sell or the solicitation of an offer to buy, nor shall there be any sale of, these securities in any state in which such offer, solicitation, or sale would be unlawful prior to registration or qualification under the securities laws of any such state.
For more information about vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. Copies of the final prospectus can be obtained from Vanguard. Please note that a preliminary prospectus is subject to change.
Total International Bond Index Fund is subject to currency hedging risk, which is the chance that currency hedging transactions may not perfectly offset the fund's foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. The fund will incur expenses to hedge its currency exposure.
Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Bonds of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets. Diversification does not ensure a profit or protect against a loss. Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Bonds and bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the Fund name refers to the approximate year (the target date) when an investor in the Fund would retire and leave the work force. The Fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date.
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