Building an International Bond Portfolio

By that I mean a portfolio made up of 60% equities and 40% bonds.

It’s a pretty standard request designed to balance risk and reward for most people.

(Whether that’s true today is debatable. It certainly wasn’t in 2022 where practically everything dropped.)

But, that said, how we see a foreign asset manager build a bond portfolio in today’s investment climate is a lot different than how it was done 15 or 20 years ago.

Let’s take a closer look, starting with the options.

#1: Government Bonds

When going overseas, you’ll often find a correlation between governments that are in good financial health and those that offer very low yields. Switzerland is the leader in this area, but other countries like Singapore fall into this group as well.

On the other hand, certain government bonds offer very high yields on the surface. But at the same time, those countries may struggle with high inflation and currencies that lose value against the greenback. Or, more simply put, the actual return can be much less than the headline yield suggests. Countries that fall into this bucket include Turkey, Egypt, and Nigeria.

#2: Corporate Bonds

Same basic concept as in the US, with investment-grade and high-yield options depending on your risk profile.

But there are some important qualifiers when looking overseas.

First, there can be a big difference between corporate bonds issued in a developed country versus one from an emerging market. Companies are run differently from one place to another, with different local rules and regulations. In some cases, this can be an advantage; in others not so much. And the local regulatory environment matters A LOT. Some countries have stricter rules and better protections for investors than others.

Second, it’s important to note that a lot of corporations in markets smaller than the US (which is to say, many of them) do business all over the world. So buying a bond issued by a Swiss or Dutch company, for example, isn’t necessarily a bet on that country’s economy. You’re often getting exposure to a company that makes its money in dozens of different markets.

Of course, there are plenty of other international bond options beyond the basics, including covered bonds (a European specialty), floating-rate notes, inflation-linked bonds, convertible bonds and supranational bonds.

But for most portfolios, most of the time, bond exposure is limited to either debt from a government or a company.

In terms of advantages, international bonds are – for the most part – a stable and dare I say, even boring way to build dollar diversification into your portfolio.

First, you’re not keeping all your eggs in the US basket. You’re getting exposure to a different country and its underlying economy.

You’re getting currency diversification of course, with an opportunity to hold an asset denominated in a more stable money.

In some cases, you can earn higher yields. In practice, though, higher yields usually reflect the additional risk you’re taking on – most often credit risk.

Tapping into international bonds also gives you more investment opportunities. You can choose from a much larger universe of bond issuers.

And of course, currency changes can work both ways. Yes, your return can drop if the US dollar strengthens against a bond denominated in a foreign currency. But the reverse is also true – holding bonds in a currency that strengthens against the US dollar improves your overall return.

Of course, it’s important to look at the negatives too.

First, buying government or corporate bonds in another country exposes you to political and economic risks from that country.

Credit risk – especially on the high-yield corporate side of the market. But governments go bust too from time to time. And when they do, investors can end up taking a serious haircut.

Interest rate risk – if interest rates rise, the market value of existing bonds usually falls – can also be a problem.

So how do we see bonds used in portfolios today?

Funny enough, because government bonds from countries in good financial health aren’t generally yielding much, we’ve seen intelligent investors and asset managers do two things.

First, they are swapping government bonds for high-grade corporate bonds — strong-rated paper that pays a meaningfully better yield, in exchange for accepting somewhat more risk.

Second, they are buying high-quality companies with long histories of dividend payments, letting the equities themselves serve as a source of ongoing cash flow. In that sense, dividend stocks become a sort of bond substitute.

Depending on a client’s risk profile, we’re also seeing convertible bonds, the buying of put options on the dividend-bearing stocks to put a floor under their prices, and the use of notes or money-market-type funds for short-term cash management.

But for the simplest cases, a focus on corporate bonds instead of government bonds, and equities as a stand-in for income, is doing some of the traditional work of bonds in a low-yield world.

P.S. Looking to build an international bond portfolio but not sure where to get started? Feel free to get in touch.