We are periodically asked if we should invest in foreign bonds.  We view the bond portfolio as the ‘safe’ ballast of the portfolio.  We believe that everyone understands that stocks can go up and down, but that the bond portfolio should be steady.  Our view, then, is that any new sub-sector should have risk/return characteristics that look a lot like a core domestic bond portfolio.

As a former foreign bond trader, I can tell you that the returns are far more related to the currency returns than the actual bond returns.  Therefore, foreign bonds would not fit the mold since currencies are traditionally more volatile than domestic bonds.  Furthermore, it is my belief that the expected returns on currency movements is ultimately zero, since currency investing is essentially a zero-sum game (unlike stocks where earnings can in theory grow indefinitely).

So, for us to make an investment in foreign bonds, the yields would have to be very attractive compared to offset the currency risk.  Right now, that isn’t the case.  Here are some data points from various bond ETFs that track various indexes:

Independently, neither of the first two alternatives are a good comparison to the Agg because the durations are so different: one is half the duration and the other has a 50 percent longer duration.  For this reason, I created a third alternative based on a 45 percent weight to Alt 1 and a 55 percent weight to Alt 2, which gives us a duration that largely matches the Agg. 

With a similar duration, we can see that there is no yield pickup for investing overseas and the credit quality is nine rungs lower by going overseas.  Two corporate bond ETFs could be used to create a portfolio with a 2.23 yield to matuirty, 4.28 year duration, single-A credit quality and no currency risk. 

We continually evaluate various bond strategies and will incorporate new ideas when we believe that we are appropriately compensated for the additional risks.