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.

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