Will Bond Indexing Topple Foreign Exchange Market Transactions

Investors frequently include foreign or international bonds in their portfolios for two important reasons; to benefit from the higher interest rates and to diversify their assets.

Bond index finds present the simplest and most efficient way to invest in foreign bonds. Also known as bond indexing, the technique is cost-effective since it allows extensive diversification and is easily understood by an average investor.

However, the high returns expected from investing in foreign bonds are affected by the increased risk from adverse currency fluctuations. Currency volatility has a significant impact on the returns of a bond due to the low levels of absolute returns present.

Governments and multinational companies routinely issue bonds that are dominated in other currencies to match their cash flows and to benefit from low borrowing costs.

Brief Introduction to Bonds

The bonds are classified as follows:

  • Foreign BondsIt is a bond issued by a foreign institution or company in a country other than its own and also denominated in the currency of that foreign country where the bond is being issued. For instance, a US company issuing a British Sterling currency bond in London.
  • EurobondAlso known as an external bond, it is an international bond that is denominated in a different currency from the native country issuing it. A British company may issue a U.S. denominated bond in China. The term is not confined to bonds issued in Europe only but applies to any bond issued in a particular jurisdiction.
  • Foreign-pay BondIt is a foreign bond that is issued by a local company in its native country.

Understanding various types of bonds gives insight about how currency risk occurs and ways to mitigate it. Note that currency risk arises from the currency denominating the issued bond and the location of the investor but not the residence of the issuer. For example, a US investor holding a yen-denominated bond issued by IBM is exposed to currency risk.

Bond Investing Strategies

When it comes to making bond investments, investors can choose from different strategies, depending on the role that the bonds play in their portfolios. Passive investment strategies involve the buyer purchasing and holding the bonds until maturity and investing in securities that track bond indexes.

Active strategies, in contrast, involve trying to outperform bond indexes, which is achieved by buying and selling bonds to take advantage of price changes. Passive investment strategies are ideal for investors who seek traditional benefits of bonds like capital preservation and diversification without capitalizing on the interest rate.

Traders seeking such benefits use investment strategies that match the performance of bond indexes, which is a technique known as bond indexing. It is used to measure the value of a section of a bond market. Investors select a bond portfolio whose performance matches that of a particular bond index like the Barclays US Aggregate Index.

The bond index is calculated from the prices of particular bonds (usually a weighted average) and used by investors to compare returns on certain investments and describe the performance of the entire market.

Benefits of Investing in Bond Index Funds

Low costs

The average domestic taxable bond fund has a lower expense ratio (the portion of assets fund companies take annually to pay off expenses) than that of an international bond. For example, investors can find an S&P 500 Index fund with an expense ratio of 0.2% or less.

The fee accounts for a significant amount of an investor’s cash over time, especially where the company deducts the costs regardless of how the funds perform.

Bond index funds reduce the impact of the fees as they require fewer resources to manage. Further, the similarity of funds within specific categories allows investors to shop for funds at the lowest cost, hence maximizing their long-term returns.

Consistent Performance

Investors holding bond index funds are confident they will get a return representative of the wider market. Active portfolio managers are hard-pressed to outperform the bond index, thus their performance is rather inconsistent. In one year, the manager beats the index by three points while the next year, there is a lag by four points.

The inconsistency is occasioned by the high fee that takes a large chunk of the returns and the need to take on more risk. According to an expert advisor, investors ought to decide if the high fee is worth the uneven performance of an actively managed fund.

How the Bond Index Affects Foreign Market Transactions

A substantial portion of bond index funds, whose benchmark is the Barclays US Aggregate Index, is invested in government related securities. It means they experience high-interest rate risk when yields are falling; a negative feature for portfolios that are heavily tilted to government bonds.

According to John Bogle, the founder of the Vanguard Group investors should look for ways to augment their portfolios with investments that experience low-interest rate risk or corporate heavy bond funds.

The Vanguard Bond Market Index Fund and the Vanguard Total Bond Market Index Fund Admiral Shares only account for a section of the bond market (the domestic market) since they are indexed to the Barclays US Aggregate Index.

Local, investment grade bonds do not provide exposure to Treasury Inflation Protected Securities, high-yield bonds, municipal bonds, and international bonds. It means that investors who have portfolios in Vanguard Total Bond Market are not wholly diversified in terms of geographies and different risk factors.

Conclusion

The takeaway here is that bond indexing is inexpensive and poses a low risk for investors creating a portfolio this way. However, traders ought to supplement it with other assets to round out their portfolio. This need is likely to grow due to the increasing size of international corporate bond markets.