Why low correlations between asset classes benefit investors

Market Realist

An investor’s key guide to international bond funds (Part 6 of 7)

(Continued from Part 5)

Low correlations: Implications for your portfolio 

The practice of allocating an investor’s portfolio across different asset classes is known as “diversification.” A diversified portfolio—one in which funds are divided among various asset classes, like stocks, bonds, or real estate—would usually have lower risk than a non-diversified portfolio, as the factors that are significant value drivers for one asset class would have limited or no impact on another asset class.

In the last part of this series, we saw how price movements for ETFs investing in U.S. stocks (SPY) and bonds like the iShares 7–10 Year Treasury Bond ETF (IEF) and the Core Total U.S. Bond Market ETF (AGG) had low correlations with the price movements of international bond ETFs like the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and the SPDR Barclays International Treasury Bond ETF (BWX).

The low and negative correlations imply that bond price movements in overseas and domestic bonds often move independently of each other and sometimes not even in the same direction. Due to this trend, investors may realize significant diversification benefits for their portfolios by investing a percentage of their portfolio holdings in international bond funds. If stock or bond prices in the U.S. go down, investors will be protected, as the possible appreciation of investments made in overseas asset classes like international bond funds may help mitigate the loss on the portfolio.

The impact of country-specific monetary policy on bond funds

For example, the U.S. economy gaining traction has meant the Fed winding down its monetary stimulus program that it started in the wake of the Great Recession and financial crisis in 2008. The Fed has reduced is monthly bond buying program by $40 billion per month to $45 billion per month (announcing a $10 billion-per-month reduction at the last four FOMC meetings). The Fed is expected to end its monthly bond purchases completely by the fall of this year. The Fed has also said it will consider increases in the base rate after its asset purchases end. Base rate increases are widely expected to occur sometime between Q2 and Q4 2015. Rate increases are also likely to translate across the credit and maturity bond spectrum, and this would lead to a fall in bond prices. This would affect the prices of U.S. debt and impact ETFs like IEF and AGG.

However, some countries, like China, are undergoing a slowdown in economic activity. The monthly purchasing managers’ index (or PMI) report issued by HSBC/Markit Intelligence has shown that manufacturing activity in the Chinese economy has contracted in the first four months of 2014, coming in lower than the critical level of 50, which represents the dividing line between manufacturing expansion and contraction. So the Chinese government may take steps to boost economic growth, including monetary easing. An accommodative monetary policy stance by the People’s Bank of China (or PBOC) would lower interest rates and positively impact yuan-denominated bond prices.

However, this appreciation in bond prices also comes with a caveat. The Chinese government would also try and stimulate exports, which are a very key component of its economy, by trying to keep the yuan exchange rate low versus the dollar, which would make Chinese exports more competitive in international markets. A depreciating yuan will lower returns on bond funds in U.S. dollar terms. So investors must be careful in their ETF selection. ETFs that invest in U.S. dollar-denominated international bonds would eradicate exchange rate risks for investors.

ETFs providing exposure to U.S. dollar–denominated debt issued by Chinese companies include the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB). Debt issued by Chinese companies, including the Sinopec Group Overseas Development, accounts for 3.43% of EMB’s assets.

EMB tracks the JP Morgan EMBI Global Core Index. The index is a broad, diverse, U.S. dollar–denominated emerging markets debt benchmark that tracks the total return of actively traded debt instruments in emerging market countries. EMB provides exposure to U.S. dollar–denominated sovereign debt and corporate debt issued in over 30 emerging markets. With an expense ratio of 0.6%, EMB has net assets of ~$4.4 billion (as of April 30).

To read about how the Chinese PMI may influence demand for Treasury securities, please read the Market Realist series  Why the decrease in China’s PMI means higher demand for Treasuries.

To find out about the risks you should consider before investing in overseas bond funds, please read on to Part 7.

Continue to Part 7

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