Creative Planning

I n t e r nat i o na l b o n d s
Peter Mallouk, J.D., MBA, CFP Chief Investment Officer www.thinkingbeyond.com

Wealth management UPDATE june 13th, 2013

The bond market continues to receive intense coverage. In our effort to provide clear information about the bond markets, this is our third letter in a four part series on bonds, with this letter addressing the sub-asset class of international bonds. Investors as a group have traditionally held a small, albeit rising, fraction of their portfolios in foreign bonds, with just 13% of fixed income assets invested in foreign bonds and 87% invested in US bonds. This is despite the fact that international bonds are actually the largest asset class, making up a full one-third of the capital markets.

Source: Vanguard (2013)

There have been many good reasons for this. First, until recently, there has not been a cost effective way to invest in foreign bonds. Purchasing these bonds individually forces even very wealthy investors to sacrifice a large spread on each bond purchased. International bond funds often came with large commissions or ongoing fees. While a few excellent options emerged in recent years that are no commission and low cost, they are unhedged funds. This basically means the funds absorb a high degree of currency risk. When the dollar is weak, the unhedged foreign bonds will perform better, and when the dollar is strong, they will perform worse. If this is the case, and hedged international bond funds will lower portfolio volatility and downside risk, why would a bond manager run a fund unhedged? The primary reason is that the cost of hedging a portfolio is expensive, as the manager essentially needs to pay for insurance against currency fluctuations, diluting the return. Another reason is that some investors purposefully seek out currency risk since, in many instances, a portfolio becomes less risky by adding a riskier asset. For example, a portfolio of 100% bonds sounds conservative, but subjects the portfolio to very high interest rate risk.
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I n t e r nat i o na l b o n d s
This is the risk that interest rates will rise, driving down the values of the bonds and diminishing the portfolios odds of keeping up with or staying ahead of inflation. Ultimately, this negatively impacts the portfolios purchasing power, and all money is good for is its ability to purchase things. By adding a riskier asset class to the portfolio, such as real estate or stocks, the portfolio is less susceptible to this specific risk. A similar case can be made for allowing currency risk into a portfolio. For some investors, an unhedged international bond fund makes sense because the introduction of currency risk may make a given portfolio better diversified. However, for the majority of our clients, especially those with equities in their portfolio, we have already adjusted for this risk in other ways, and would prefer a lower cost, less volatile solution for the foreign bond space. This month, Vanguard is launching a new foreign bond ETF and institutional fund that will have no commission, the lowest expense ratio in the industry, and will have the scale and size to hedge the portfolio cost effectively. While our current foreign bond funds have done very well for our clients over the years, the last few months notwithstanding, this alternative provides exposure to the foreign bond market in a less volatile and more cost effective manner. For clients whose strategy best calls for hedged bond holdings, we plan to sell our foreign bond funds and replace the positions with this new holding and other holdings that may apply in your particular situation. This new offering also provides us with a new ETF to utilize to tax harvest our international bond positions as opportunities arise. The foreign bond market is the largest capital market in the world and has a place in many investors portfolios. We remain committed to the asset class and committed to our ongoing search to utilize the best possible holding in every investment space. CREATIVE PLANNING Private wealth management

Wealth management UPDATE june 13th, 2013

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3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com