The size and diversity of non-dollar bond markets suggest that non-dollar bonds belong in diversified portfolios. But the risk and return characteristics of foreign bonds raise questions regarding their role in diversified portfolios of U.S. investors.
Unhedged foreign bond portfolios embody a substantial component of currency risk, for which U.S. investors appear to receive no reliable compensation (unless they are exceptionally talented foreign exchange traders). Hedging the currency risk of foreign bond portfolios can reduce their volatility by more than half. But hedging entails additional costs, which can reduce expected return materially.
Skillful management of a non-dollar bond portfolio can add value, to be sure. But absent superior active management to carry the day, foreign bonds make only a modest contribution to portfolios that already include foreign stock and real estate in addition to U.S. stock and fixed income securities. Many investors will conclude that foreign bonds are a diversification opportunity they can afford to pass up. This is especially true for smaller funds with limited resources. Larger investors stand to gain more from diversification into foreign bonds.
