(Re)validating the case for international bonds

We are constantly evaluating our TDFs to ensure we have the right design and asset allocation to help our investors achieve a successful retirement. Recently, our Investment Strategy Group took a deeper look into our current fixed income exposure with a key question in mind: Should we change the fixed income home bias?

Our updated research reaffirms how and why this asset class continues to add value for investors. It also upholds our belief that maintaining a meaningful allocation to international bonds (30% of the total fixed income exposure) is a sufficient way for investors to improve risk-adjusted returns within their portfolios.

Because of Vanguard’s belief in the benefits of diversification, we were the first TDF provider to include meaningful exposure to international bonds within our glide-path sub-asset allocation in 2013 (further increasing our exposure in 2015).

In practice, this results in 30% of the bond allocation throughout Vanguard’s glide path allotted to international bonds. We achieve this using Vanguard Total International Bond II Index Fund, which provides broad exposure to non-U.S. investment-grade bonds, including international government, agency, and corporate securities from developed countries and emerging markets countries.

Compared with a U.S.-only bond portfolio, an investor with an allocation to international bonds benefits from diversified exposure to more securities (7,000 plus), yield curves, countries (40 plus), and macroeconomic regimes. This approach allows investors in Vanguard TDFs to capitalize on the benefits that fixed income securities, broadly, have provided investors for decades while not being overly concentrated in one country’s economic environment.

With that said, we do not believe in diversification for the sake of diversification. We are selective in what sub-asset classes we include. For example, high-yield bonds—and domestic high-yield bonds for that matter—are excluded. This decision is a result of Vanguard’s research showing high-yield bonds’ high correlation with equity markets, lessening their diversification benefits.

A clear demonstration of Vanguard’s thoughtfulness around asset allocation is our use of hedged international bonds within our TDFs. Currency hedging the allocation back to the U.S. dollar can provide the investor with the desired return stream without it being subject to excess volatility from movements in currency markets.

Figure 2 shows the impact that currency hedging has on international bond volatility. Currency hedging international bonds reduced the volatility of the asset class by 64%.

When measuring glide-path success, we use two goal-based metrics: certainty fee equivalent (CFE) and probability of success. The CFE is the variable that determines the amount an investor is willing to pay to invest in an improved glide path (e.g., the optimized one) relative to a reference glide path (e.g., the current one). Probability of success refers to the likelihood that a particular glide path will meet an investor’s spending goals through retirement across the full range of economic scenarios.

In reevaluating the case for fixed income in TDFs, our updated research supports our existing use of international bonds and Vanguard’s home bias. We assessed both age-varying fixed income home bias and static fixed income home bias and found that altering our existing approach did not have a materially positive impact on either model-based metric.

Through our first approach, we sought to evaluate whether fixed income home bias could vary with age in a glide path. This will lead to different home bias across different vintages. We found that age-varying home bias does not offer any meaningful improvement to investor outcomes. Moreover, this negligible improvement comes with added complexity that could have adverse effects for the end investor.

Through our second approach, we sought to evaluate different fixed income allocations within TDFs when the fixed income home bias remains the same for all ages in a glide path. This will lead to the same home bias across different vintages. Currently, the fixed income allocation in our TDFs is composed of a 70% allocation to U.S. bonds and 30% allocation to international bonds.

We found that increasing the share of U.S. bonds in the portfolio does not improve investors’ retirement outcomes. In fact, as U.S. bond allocation increases, the portfolio loses the diversification benefits of international bonds, and the CFE decreases. In addition, decreasing the share of U.S. bonds does not improve investors’ retirement outcomes in any material way, leading to the recommendation to retain our current level of home bias.

In practice, this means Vanguard’s TDFs will maintain a 70/30 home bias, with 70% of the bond exposure held in U.S. bonds and the residual 30% invested in international fixed income securities, throughout the entirety of the glide path. In addition, the underlying sub-asset allocation will remain the same, and we will continue to include both developing and emerging markets at their weights per the indexes. Investors using TDFs as the sole or primary retirement plan holding will find that our results reflect the most beneficial outcome.

Vanguard prides itself on continuously looking for ways to improve retirement savings outcomes for investors. The goal of our TDFs and annual due diligence is to answer the question: How can we best serve a range of investors? This line of thinking guides the research we conduct in the TDF space. It also ensures that our TDFs reflect our best thinking on glide-path design and sub-asset allocation.

The case for international bonds is one that is constantly debated. However, unlike with competitor offerings, our debates do not result in constant change to our TDFs. The most recent review resulted in a simple yet meaningful decision to maintain our current allocations. Vanguard’s willingness to avoid change for the sake of change has driven outcomes for the past decade and, based on our research, should continue to drive outcomes in the future.