To make your pension fund portfolio less risky, you need to do something that feels dangerous: invest overseas.
If you are like most people, you may have put too much money into pension funds in your home market and as a result your bets were not spread.
“People are used to thinking about diversifying their equity portfolios and they understand how this works to control risk,” said Rob Waldner, chief fixed income strategist at Invesco. “You have to do the same with your fixed income.”
Bond diversification is all the more important when traditional income producers like US Treasuries pay meager interest rates, he said.
With the onset of the pandemic, bond yields are rising – the 10-year US Treasury Department, a benchmark bond, paid 1.7 percent in early April, compared with less than 1 percent in January. In a long-term comparison, however, interest rates are likely to remain relatively low.
Bonds come in a variety that is as rich – and sometimes confusing – as the screwdriver at Home Depot.
A well-diversified portfolio may include mutual or exchange-traded funds that buy bonds issued by the United States and foreign governments, as well as large US and foreign corporations, as well as those that are backed by mortgages, auto loans, or credit card claims in the United States. (Pools of these financial assets become securitized, and the rights to payment from the pools become mortgage-backed and asset-backed bonds.)
Home bias is the financial term for people’s tendency to over-invest in their home market and stay away from other places. Investment experts say it is ubiquitous.
“We see this in every country,” said Roger Aliaga-Diaz, global director of portfolio construction at Vanguard.
Do-it-yourself investors typically keep around 85 percent of their bond investments in their home market, Aliaga-Diaz said.
In contrast, people who buy into Vanguard’s U.S. pension funds as of the cut-off date (which handle asset allocation for their shareholders) have about 70 percent of the bond portion of their money invested domestically and 30 percent overseas, he said.
Research from Vanguard has shown that international bonds reduce the ups and downs of portfolios without detracting from overall returns. International diversification can provide access to securities from more than 40 countries.
“This broad exposure is important because the factors influencing international bond prices are relatively uncorrelated to those influencing US prices,” the report said. Recently, for example, South Korea’s 10-year government bond is yielding 2 percent, while Mexico’s is yielding almost 7 percent.
The international bond portion of the Vanguard funds as of the reporting date is invested in the Vanguard Total International Bond Index Fund, which mainly holds bonds from developed countries. Like many international pension funds, the company uses hedging to protect its shareholders from the volatility of returns caused by currency fluctuations.
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April 8, 2021, 9:35 a.m. ET
Jean Boivin, head of the BlackRock Investment Institute, said research into his outfit suggests investors want to be bold in their foreign bond forays and look beyond developed markets.
“You have to think about bonds from emerging markets and especially Asia ex Japan,” he said.
In the past, investors could see the US bond market as a proxy for the world, also because US companies often had far-reaching international activities, Boivin said. But today there is enormous global diversity. Foreign markets, especially China, have grown so much that this approach doesn’t work as well.
A person’s precise interest in emerging market bonds or a particular sub-class of bonds will be determined by that person’s risk tolerance and other assets. BlackRock’s broadly diversified Total Return Fund could provide a starting point for reviewing appropriate areas. The company recently allocated around 8.6 percent of its assets to emerging markets.
Another broad offering, the Fidelity Total Bond Fund recently had a 16 percent stake in higher-yielding, higher-risk types of domestic and foreign debt.
“In the past, we owned 8 to 18 percent of the higher-yielding sectors,” said Celso Munoz, a fund manager. “It is appropriate for most people to get involved in the broader world of fixed income, which includes high yield bonds, emerging markets, and bank loans.”
People may tend to avoid international bonds, in part because stocks overshadow bonds in popular media, said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research.
“Every day someone talks about the S&P 500 or the Dow,” she said. “People don’t talk that much about the Bloomberg Barclays US Aggregate Bond Index,” a leading bond index, and relatively few people delve deeper into the fixed income universe.
To decide how to better diversify your retirement funds, think about why you own them, said Tad Rivelle, chief investment officer for fixed income at TCW.
“The existential question is do you view fixed income securities as a safe asset that allows you to take risks elsewhere,” he said in a market panic? “
Members of the former group might prefer more traditional fixed-income categories like government bonds and investment-grade corporate and mortgage bonds, while the latter may also opt for high-yield bonds or a wider range of securitized rates, he said. TCW’s MetWest Total Return Bond Fund could work for the first group and the MetWest Flexible Income Fund for the second group.
A mystery to all bond fund investors is how the end of the Covid-19 pandemic could affect interest rates.
Interest rates usually rise when the economy grows, as is expected when the world emerges from the pandemic. If so, inflation could rise, stifling a long bull market for bonds. Bond prices rise as interest rates fall.
However, re-inflation has been mistakenly predicted, and Federal Reserve Chairman Jerome Powell has made it clear that the bank is in no rush to hike the short-term rates it controls.
For investors who rely on their pension funds for their returns, persistently low interest rates could be a temptation to take the risk in court.
A more patient approach is prudent, said Mary Ellen Stanek, chief investment officer of Baird Advisors, which oversees the Baird Funds.
“You have no ties to excitement and drama,” she said. “You own them for predictability and lower volatility.”
Ms. Jones von Schwab also warned against aiming for undue risk. She suggested investors rethink how they withdraw cash from their portfolios instead.
“In a year where your stocks are up 20 percent and your bonds are up 2 percent, you may want to take some of those capital gains and put them in your cash bucket,” she said. “Suppose you want to generate a total of 6 percent and you have earned 20 percent in shares. If you have an excess over your plan, consider that as potential income. “
Whichever route investors choose, they should always pay close attention to the cost of funds and ETFs, said Jennifer Ellison, a financial advisor at Bingham, Osborn & Scarborough in San Francisco.
“The cost is really important, especially with returns where they are,” she said, as those costs will consume much of that small return. “If you are a retail investor and you buy a loaded retirement fund, you are giving up all of your returns.”