Why Invest in International Bonds? - Diversification and Yield
Japanese government bond yields have remained extremely low for many years, with the 10-year JGB yield only recovering to around 1% as of 2024. Meanwhile, the US 10-year Treasury yields around 4%, and the Australian 10-year bond offers yields in the upper 4% range. This interest rate differential is the primary motivation for Japanese investors to look at international bonds. Furthermore, since interest rate cycles across countries are not perfectly synchronized, holding bonds from multiple countries can smooth out yield fluctuations across the overall portfolio.
The diversification benefit of international bonds is also evident in their correlation with equities. US Treasuries tend to rise in price during sharp equity market declines (flight to quality), serving as a cushion for the portfolio. However, in rising rate environments like 2022, stocks and bonds can fall simultaneously in a 'double punch,' requiring flexible responses depending on the interest rate environment.
Comparing Developed and Emerging Market Bonds
Developed market bonds (US Treasuries, German Bunds, UK Gilts, etc.) carry low credit risk and high liquidity, but offer relatively lower yields. Funds tracking the FTSE World Government Bond Index (ex-Japan) provide low-cost, broad diversification across developed market bonds. Emerging market bonds offer higher yields but come with default risk and currency depreciation risk.Introductory books on bond investing systematically organize the characteristics of various bond types.
Currency Hedging - Decision Criteria and Practice
The biggest debate in international bond investing is whether to hedge currency risk. Currency hedging eliminates exchange rate fluctuation risk but incurs a hedging cost (roughly equivalent to the short-term interest rate differential between the two countries). With the US-Japan interest rate differential at approximately 3-4% as of 2024, hedging costs significantly erode the yield advantage of international bonds. If you want to avoid short-term currency fluctuations, hedged products are advantageous for stability. For long-term investing where you expect the smoothing effect of currency movements, unhedged products are the more rational choice.
A reasonable guideline is to allocate 30-50% of the bond portion of your portfolio to international bonds, managing risk through combination with domestic bonds.Books on currency hedging strategies can also serve as a reference for decision-making.
Next Steps for Starting International Bond Investing
To incorporate international bonds into your portfolio, start by reviewing your current bond allocation. If your bond portion consists solely of Japanese government bonds and bank deposits, adding 30-50% in international bonds can improve yield and provide diversification benefits. The simplest approach is to systematically invest in eMAXIS Slim Developed Market Bond Index (tracking the FTSE World Government Bond Index) through your NISA account. With an expense ratio of approximately 0.15% per year, it provides broad diversification across developed market bonds in the US, Europe, Australia, and beyond.
Make your currency hedging decision based on your investment horizon and the interest rate environment. In the current environment of a large US-Japan interest rate differential, hedging costs are high, making unhedged products appear more attractive - but you also need to consider the risk of future yen appreciation. If you are unsure, a practical starting point is to hold hedged and unhedged products in a 50:50 split. Bond investing may seem less exciting compared to equities, but it plays a vital role in enhancing the stability of your overall portfolio.