Vanguard: Look overseas to lower interest rate risk

International bond rates are 'imperfectly correlated' to equity markets

Nov 22, 2013 @ 12:01 am

By Jason Kephart

Interest rate risk has conservative bond investors spooked and looking at lower-quality fixed income for comfort, but the real salve may be outside the United States, according to The Vanguard Group Inc.

Bond prices move inversely to rates, and with rates looking much more likely to go up than down, hedging against losses in bond portfolios is of critical importance to many investors.

The most common way to lower rate risk this year has been to trade it for credit risk, which means investors have been paring down high-quality bonds in favor of riskier bonds that offer higher yields.

Mutual fund and exchange-traded fund ownership of Treasuries, generally regarded as the least likely bonds to default but the biggest sitting ducks for rate movements, has fallen to 8%, from 12% in 2009, according to Vanguard.

Assets in mutual funds and ETFs that invest in lower-credit-quality bonds, such as floating-rate notes, high-yield bonds and emerging-markets debt, have grown by 163% to $523 billion over the same time period, according to Morningstar Inc.

The higher yields that those lower-quality bonds offer can act as a cushion against rising rates, but they come with a much higher correlation to the equity market.

For investors who aren't comfortable with bonds that aren't likely to act like bonds when there is a stock market correction, there may be a better way, said Chris Philips, a senior analyst in Vanguard's Investment Strategy Group.

“High-quality international bonds offer a simple way to buffer a bond portfolio from rising interest rates,” he said.

That is because international rates are “imperfectly correlated” and don't tend to rise at the same time or at the same pace, even though over a longer time period they tend move in the same general direction.

Because they aren't all moving in tandem, they can offset each other over the short term, offering a smoother ride and increased returns, Mr. Phillips said.

There is one caveat, though. To benefit from international bonds, financial advisers have to strip away the currency component.

“Currency is three times as risky as bond risk,” Mr. Phillips said. “Unhedged international bonds actually increase the risk of a portfolio.”

Removing the currency lets international bonds perform as bonds, lowering overall portfolio risk and protecting against an oversize stock market correction.

0
Comments

What do you think?

View comments

Recommended for you

Featured video

Events

Dynasty's Penney: Top RIA trends for 2018

What's next for RIAs? Dynasty's Shirl Penney talks about the growing numbers of entrepreneurial advisers. Plus, what inspired his own entrepreneurship.

Latest news & opinion

Meet our 2017 Women to Watch

Introducing 20 female financial advisers and industry executives who are distinguished leaders, advancing the business of providing advice through their creativity and hard work.

Raymond James executives call on industry to keep broker protocol

Also ask firms to pay for the administration of the protocol to 'ensure its longevity and relevance.'

Senate committee approves tax plan but full passage not assured

Several Republican senators expressed reservations about the bill, and the GOP cannot afford too many defections.

House passes tax bill, focus turns to Senate

Tax reform legislation expected to have more of a challenge in upper chamber.

SEC enforcement of advisers drops in Trump era

The agency pursued 82 cases against advisers and firms in fiscal year 2017, down from 98 the previous year.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print