Investing for retirement often brings to mind familiar instruments like S&P 500 stocks or U.S. Treasury bonds. However, this familiarity can lead to a significant home bias within portfolios, overlooking a crucial asset class: international bonds. Representing a substantial portion of the global investable market, international bonds offer diversification benefits that can significantly enhance long-term retirement outcomes. This article explores the strategic importance of international bonds in target-date funds (TDFs), highlighting Vanguard’s approach and the research supporting their inclusion.
Why International Bonds Matter in Retirement Planning
Many investors underestimate the size and scope of the international bond market. It constitutes approximately 24% of the overall liquid, investable market and a remarkable 52% of the global bond market. This vast market offers a wealth of opportunities for diversification, providing exposure to a broader range of economies, interest rate environments, and macroeconomic conditions than a U.S.-centric bond portfolio. By including international bonds, investors can reduce their dependence on the performance of a single country’s economy, potentially mitigating risks and enhancing returns.
Fig 1. Percentage of Global Capital Market and Global Fixed Income Market allocated to international bonds (Data as of March 31, 2023)
Vanguard’s Pioneering Approach to International Bond Integration
Vanguard recognized the importance of international bond diversification early on, becoming the first TDF provider to incorporate significant exposure to this asset class in 2013, further increasing the allocation in 2015. Vanguard TDFs maintain a 30% allocation to international bonds throughout the glide path, utilizing the Vanguard Total International Bond II Index Fund. This fund offers broad exposure to non-U.S. investment-grade bonds, encompassing government, agency, and corporate securities from both developed and emerging markets. This diversified approach grants access to over 7,000 securities, numerous yield curves, and a wide range of countries (40+), creating a more resilient portfolio.
Fig 2. Sample glide path demonstrating asset allocation over time, including international bonds.
The Value of Currency Hedging
A key element of Vanguard’s strategy is the use of currency hedging for international bond holdings. Currency fluctuations can introduce significant volatility to returns, potentially offsetting the diversification benefits. By hedging the international bond allocation back to the U.S. dollar, Vanguard aims to mitigate this currency risk, providing a more stable return stream. This practice significantly reduces the volatility associated with international bond investments, making them a more predictable component of a retirement portfolio.
Fig 3. Volatility reduction achieved through currency hedging of international bonds.
Re-affirming the Strategy: Research and Conviction
Vanguard continually reviews and refines its investment strategies, ensuring they align with investor needs and market dynamics. Recent research, conducted using the Vanguard Life-Cycle Investing Model (VLCM), reaffirms the value of international bonds in TDFs. The VLCM analyzes the impact of various glide paths on investor outcomes, considering factors like risk tolerance, retirement funding needs, and savings rates. The research focused on two key metrics: Certainty Fee Equivalent (CFE) and probability of success. CFE represents the amount an investor would be willing to pay for a superior glide path, while the probability of success measures the likelihood of meeting retirement spending goals.
Exploring Age-Varying and Static Home Bias
The research explored two approaches to international bond allocation: age-varying and static fixed income home bias. The age-varying approach considers adjusting the home bias as an investor progresses through the glide path. However, the research found that this approach offered negligible improvements while introducing unnecessary complexity. The static home bias approach maintains a consistent allocation throughout the glide path, as currently implemented by Vanguard. The research confirmed that altering this approach, either by increasing or decreasing the U.S. bond allocation, did not materially improve investor outcomes. In fact, increasing the U.S. bond allocation diminished the diversification benefits provided by international bonds, leading to a lower CFE.
Maintaining the Optimal Balance: 70/30 Home Bias
Based on this comprehensive research, Vanguard maintains its 70/30 fixed income home bias within TDFs. This allocation, with 70% invested in U.S. bonds and 30% in international bonds, continues to be the optimal balance for maximizing participant outcomes. This consistent approach provides the desired diversification benefits while minimizing unnecessary complexity and volatility.
The Importance of Continuous Evaluation
Vanguard’s commitment to continuous evaluation and research ensures that its TDFs remain aligned with best practices and investor needs. While the debate surrounding international bonds persists within the investment community, Vanguard’s research-driven approach allows for informed decisions that prioritize investor outcomes. This commitment to stability and evidence-based strategies provides investors with confidence and clarity in their long-term retirement planning.
FAQs
Why are international bonds important in a diversified portfolio? International bonds broaden diversification beyond the U.S. market, providing exposure to different economies, interest rate environments, and currencies. This can potentially reduce overall portfolio risk and enhance returns.
What is currency hedging and why is it used for international bonds? Currency hedging mitigates the risk of fluctuations in foreign exchange rates impacting returns. It aims to stabilize returns by converting foreign currency gains or losses back to the investor’s base currency.
How does Vanguard determine the allocation to international bonds in its TDFs? Vanguard uses sophisticated models like the VLCM, considering factors such as risk tolerance, retirement age, and savings rates, to determine the optimal allocation. They conduct ongoing research to validate and refine their approach.
Are international bonds suitable for all investors? While international bonds offer valuable diversification benefits, individual circumstances and risk tolerances vary. It’s important to consult with a financial advisor to determine the appropriate allocation for your specific situation.
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