Will International Bond ETFs Outperform Treasuries?

Higher Interest Rates Could Send Treasuries Lower

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The Federal Reserve’s decision to hike interest rates by 25 basis points – along with its plan to steadily hike rates across 2016 – could spell the end of the rally in the U.S. bond market. While high-quality municipal bonds remain an attractive alternative, investors may want to take a look at international bonds as the best alternative. Lackluster growth and deflationary pressures across much of the rest of the world could provide a further boost to bonds.

In this article, we’ll take a look at whether international sovereign and corporate bonds are poised to outperform Treasuries and U.S. corporate bonds.

Global Stimulus Likely in 2016

The European Central Bank (ECB) is likely to introduce new stimulus measures in 2016 in order to combat tepid growth and deflationary pressures. In 2015, the central bank institute a negative interest rate policy and bond-buying programs that led to a rally in European bonds. The S&P Eurozone Sovereign Bond Index rose 5.32% between 2012 and 2015 compared to just 0.72% returns for the S&P/BGCantor US Treasury Bond Index.

With inflation of just 0.2% during the third quarter of 2015, the ECB is likely to introduce further stimulus in 2016 to reach its target rate of 2%. These stimulus measures are likely to push down yields even further into negative territory, which could lead a rally on bond prices. Ongoing bond buying programs could further boost prices of sovereign by reducing the supply of available bonds and increasing the demand side of the equation.

Japan and other developed countries outside of the U.S. are also likely to expand their own stimulus programs in an effort to combat slowing growth and deflationary pressures. For instance, the Bank of Japan (BOJ) voted against changing its monetary policy in late-2015, but the country’s inflation rate reached as low as 0.3%.

Without any signs of improvement, the country may reconsider taking a more proactive approach in 2016.

Building Exposure to Global Bonds

The easiest way to gain exposure to European bonds is through exchange-traded funds (ETFs) that hold broad portfolios. For example, the SPDR Barclays International Treasury Bond ETF (NYSE ARCA: BWX) includes roughly 7% exposure to France and Italy, as well as about 5% exposure to the Netherlands, Germany, Belgium, and Spain. Other ETFs like the Vanguard Total International Bond ETF (NYSE ARCA: BNDX) holds about 57% of its portfolio in Europe.

One of the most important risk to consider when it comes to investing in European bond ETF is the currency risk. Since these ETFs are dollar-denominated, increases in the value of the U.S. dollar relative to the euro could lead to losses upon conversion. These risks can be avoided by either hedging the risk or purchasing currency-hedged ETFs like iShares Currency Hedged International High Yield Bond ETF (NYSE ARCA: HHYX).

Those purchasing bonds directly rather than in diversified funds should also consider the geopolitical risks associated with certain countries. For example, Greek bonds pay higher yields because they have a higher chance of default than German bunds.

Countries like Japan also tend to have more unpredictable monetary policy decisions, which can lead to volatility in the market when decisions are abruptly made by the central bank.

Key Takeaway Points

  • Treasuries are poised for a long-term slide if the Federal Reserve keeps up its interest rate strategy throughout 2016, since higher interest rates tend to increase bond yields and reduce bond prices over time.
  • The best way to gain diversified exposure to international bonds is through the use of international bond ETFs; however, it’s important to take into account currency risks when investing in foreign bond funds.