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International Bonds’ Negative Yields Can Be a Positive for Target-date Funds. Really.

An allocation to international bonds exposes Target Retirement Fund investors to an asset class that’s not only influenced by different interest rate and inflation dynamics than U.S. bonds, but which also provides a larger opportunity set of credits.

  • Vanguard

More than three years ago, Vanguard added an allocation to hedged international fixed income in our Target Retirement Funds. Our primary reason was—and remains—to improve our funds’ global diversification by including an allocation to this largest publicly traded asset class in the world (Source: Vanguard, Thomson Reuters Datastream, Bloomberg, Barclays, and MSCI).

This reason holds fast even with global interest rates trending lower—indeed, some nominal yields going out five or more years have turned negative in a few developed markets in Europe and Japan. Does this mean that Vanguard is directing Target Date Fund contributions into an asset class that’s going to realize a negative return?” Of course not. This is because we mustn’t forget to take currency into account when it comes to investing in international bonds.

To explain why this is and how it’s done, let’s start by comparing U.S. Treasury yields with, say, German bund yields. It’s like comparing apples to oranges, right? Both are round fruits, but there are important differences between them. A yield on a foreign bond always carries with it the currency effects accruing to the home-based investor.

Now, here’s where we bring in the math: The currency effect should largely offset the yield differential between the domestic and the international bond, even for bonds with negative yields. This is precisely why, in the chart below, the total hedged international bond market return—including that of negative-yield bonds of Japan and Switzerland—is similar to an investor’s domestic bond market return. For U.S. investors in Vanguard Target Retirement Funds, this means that the return on hedged international bonds has tended to produce returns that have been very similar to U.S. bond market returns over time.

Returns of domestic and international bond markets from the perspective of investors in the stated country, January 1985 to October 2016

Note: “Domestic market return” is defined here as each country’s respective component of the Citigroup World Government Bond Index, with returns measured in that country’s currency. “International market return, in local terms (absent currency movement)” is defined as the Citigroup World Government Bond Index (excluding the stated country), measured in local terms. “Return contribution of hedging currency” is the difference in return between the international index measured in hedged terms versus local terms. We used France as a proxy for euro-area investors, because of a lack of history for the broad monetary area.

Sources: Vanguard calculations, based on data from Citigroup.


At this point, you’re probably wondering why anyone would invest in non-U.S. bonds if currency hedging provides returns over the long term that are likely to be similar to the U.S. bond market. The answer is simple but fundamental: the potential diversification benefit. An allocation to international bonds exposes Target Retirement Fund investors to an asset class that’s not only influenced by different interest rate and inflation dynamics than U.S. bonds, but which also provides a larger opportunity set of credits. These differences have produced an asset class that has historically had a low correlation with U.S. and international stocks and an imperfect correlation with U.S. bonds—a relationship that we believe will likely persist.

It’s perfectly understandable to see negative yield on some international bonds and assume that they’re too risky to include in a target-date fund. Yet, they serve a critically important purpose: A globally diversified allocation to investment-grade bonds is a great way to diversify one of the biggest risks that retirement plan participants face—the steep declines that can occur in a bear market for equities. Thus, despite the negative yields on some international bonds, this asset class is a powerful diversifier when doing the right financial math, and there’s nothing negative about that.


Written by Brian Scott, senior investment analyst in Vanguard’s Investment Strategy Group

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For more information about Vanguard funds, visit or call 800-523-1036 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

  • All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Past performance is not a guarantee of future results.
  • Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date.
  • Investments in bonds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Currency hedging transactions may not perfectly offset the fund’s foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. The fund will incur expenses to hedge its currency exposures.
  • Diversification does not ensure a profit or protect against a loss.
  • © 2017 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.


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