If any of our asset management clients are asked about the investment principles we follow, we would hope that “diversification” would be one of their first responses.  Diversification not only broadens the range of investment opportunities but it also tends to reduce risk because of differences in the pattern of return among the various investments. When some of the investments are going down, others may be going up, and vice versa.

It seems that most of the discussions about diversification in the media and elsewhere tend to focus on equities, and how you don’t want to own just a few stocks in case one of them takes a big nosedive.  Increasingly, investors want to diversify their equities across different parts of the world in order to take advantage of additional opportunities.  Global or foreign equity mutual funds easily can provide that broader diversification.

The same principle of “avoiding too many eggs in one basket” applies to fixed income.  Quite often, when new clients come to us, we see that they have put all of their fixed-income investments in one type of vehicle, such as CDs, or Treasury notes, or a handful of individual bonds such as corporate or municipal bonds.  However, over-concentration– in a certain issuer or type of issuer, or country or maturity date— presents risks.  During the financial crisis of 2008, investors with heavy concentrations in bonds of U.S. financial institutions (such as Citigroup, Morgan Stanley, and Bank of America) suffered significant price declines. Meanwhile, Treasury securities and bonds of top-rated companies such as Coca-Cola performed well.

As fixed-income investors fled to safety during the financial crisis and also during the European crisis, they drove prices of top-quality bonds up and their yields down. (The Federal Reserve also did its part.) As a result, 10-year Treasuries now yield only 1.77% and newly issued 7-year bonds from IBM yield only 1.875%.   While we feel quite confident that these bonds won’t default, we’re certainly not excited about their return potential.   If you buy a 10-year Treasury note and hold it until maturity, you’ll earn 1.77% a year, regardless of what’s happening to the inflation rate, interest rates in general, or other segments of the fixed-income market.  If the inflation rate averages more than 1.77%, you’re actually losing money in terms of purchasing power.

Because high-quality U.S. bonds are yielding so little, they pose a different sort of risk called interest rate risk, which refers to price declines of bonds when interest rates rise.  The longer the maturity (or duration of the bond), the greater the price decline if rates rise.   Therefore, even if we feel good about the credit quality of issuers, the bonds not only provide very little income but they also pose potential price declines if rates rise.

Therefore, we believe it is extremely beneficial to include global diversification in clients’ bond portfolios.  There are fixed-income opportunities in different parts of the world–whether the bonds are issued by governments or companies–with higher yields and total return potential than those available in the U.S.   Many countries also have lower debt levels and greater economic growth than the U.S.   It’s important to realize that they may present different types of risk, and that’s why it’s critical to select highly skilled fund managers and to diversify across countries and issuers.  Global managers have another tool to bring to the table, that of currency management, which skillful managers use to augment returns significantly. 

In sum, global managers have a much broader opportunity set to work with and the greater diversification can provide higher returns, both on an absolute and risk-adjusted basis. While we continue to invest in U.S. bonds, we want some of our bond eggs in other countries’ baskets.  As long as U.S. Treasuries continue to be considered the safest haven, they may outperform in turbulent times.  But we’re not expecting all times to be turbulent and we also think certain other countries’ bonds are gaining in stature.

Below is a graph of cumulative, 10-year total returns of three fixed-income indices:   a) in blue, the Citigroup World Government Bond Index (WGBI); b) in green, the Barclays U.S. Aggregate Bond Index; and c) in orange, the Barclays U.S. Treasury Index.  (The performance of each index is presented in U.S. dollars.)   Over the 10 years, the global (or world) bond index provided a total return of 109%, or 7.67% on an annualized basis; the U.S. broad-based aggregate index provided a total return of 74%, or 5.7% annualized; and the U.S. Treasury index provided a total return of 72%, or 5.56% annualized.  The biggest discrepancy between the two U.S. indices occurred during the financial crisis in late 2008 when investors flocked to Treasuries.  The broader U.S. “aggregate” index, which also includes corporate bonds, had a notable dip in the latter part of 2008.  The global bond index had considerably more volatility over the 10 years than the U.S. indices, but investors who sat tight were nicely compensated.  Of course, we must reiterate that past returns are no guarantee of future returns, and we’re not expecting such favorable results, especially from the U.S. indices, over the near term.  However, we think it’s likely that allocating a portion of your fixed-income portfolio to global bonds will continue to boost overall returns, assuming you sit tight.

10-Year Cumulative Total Return in a World Gov’t Bond Index (WGBI) and Two U.S. Bond Indices