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Why overseas bond funds can reduce your portfolio risk

Phalguni Soni

An investor’s key guide to international bond funds (Part 5 of 7)

(Continued from Part 4)

Don’t put all your eggs in one basket

As we discussed in the last two parts of this series, international bond funds invest in debt issued by non-U.S. or foreign issuers. They can provide valuable diversification benefits to investment portfolios, as macroeconomic factors that act as value drivers for bond returns—interest rates, GDP growth, inflation expectations and employment—vary across countries. So international bond funds like the SPDR Barclays International Treasury Bond Fund (BWX), the Vanguard Long-Term Corp Bond Index ETF (VCLT), and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) have had historically low-to-negative correlations with ETFs investing in U.S.-only assets like the iShares 20+ Year Treasury Bond (TLT) and the SPDR S&P 500 (SPY).

What are correlation coefficients?

Correlation coefficients measure the degree to which two variables move together without implying a causal relationship between them. The daily price movements of the ETFs, and therefore the correlation coefficients of the above-mentioned ETF pairs, are influenced by factors such as movements in domestic and overseas interest rates, the credit quality of the underlying bond investments, the currency movements and duration of the bond ETFs, and other factors. These factors, across countries, rarely move in coordination with each other, which causes differences in price movements between U.S. and international bonds.

Interpreting correlation readings

A correlation coefficient of 1 signifies that both variables (in this case, ETF prices) change together in perfect tandem and in the same direction. A correlation coefficient of -1 signifies that both variables move in exactly opposite directions. Zero correlations imply that the two variables move independently of each other. Very low correlations signify that there’s very little or no systematic relationship between the two variables.

The table above shows the correlation coefficients for daily fund price changes between international fixed income ETFs and domestic ETFs from January 3, 2011, to May 2, 2014. The correlation coefficients between returns on ETFs investing in U.S. assets and ETFs investing in overseas bonds in the above table range from a low of -0.19 to a high of 0.4. The lowest correlations appear to be between UST funds like TLT, SHY, and IEF and international bond funds. This is because during market turmoil, investors are known to pull funds out of overseas assets and into safe-haven assets like UST.

In the next part of this series, we’ll discuss some of the implications arising from low and negative correlations between ETFs investing in U.S. stocks and bonds and international fixed income ETFs and how investors can benefit from them. Please read on.

Continue to Part 6

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