Historical data indicate that the inclusion of non-dollar fixed-income securities in U.S. institutional portfolios can reduce portfolio risk for any level of required return. The optimal combination of U.S. and foreign securities will depend on four main factors—the level and trends of interest rates in the U.S. and abroad, the levels and trends in exchange rates, the volatilities of interest rates and exchange rates, and the correlations between them.

Investors in domestic U.S. fixed-income securities frequently employ immunization and dedication strategies in the pursuit of regular income and long-term risk-avoidance. Immunizing or dedicating portfolios of foreign currency bonds in dollar terms is extremely difficult, however. This suggests that funds placed in foreign currency fixed-income portfolios be actively managed, and their performance measured against total holding-period return and risk objectives.

In practice, the choice of a benchmark index against which to measure risk and performance apparently depends less on theory than on what sponsors will demand and portfolios managers will accept. The best candidate for an index may be a naively diversified global fixed-income portfolio composed of all currencies and maturities in proportion to their market-value weights. Since the essence of active international fixed-income portfolio management is the freedom to shift across all currencies, U.S. deposits and bonds should be included.