"The strongest argument for investing in nondollar bonds is that there are diversification benefits." Explain why you agree or disagree with this statement

Question

What will be an ideal response?

Answer 1

There are mixed empirical findings for agreeing with the statement that diversification is the strongest argument for investing in nondollar bonds. The details are supplied below.

Several reasons have been offered for why U.S. investors should allocate a portion of their fixed income portfolio to nondollar bonds. First, there is a theoretical argument which states that diversifying bond investments across countries—particularly with the currency hedged—reduces risk. This is generally demonstrated using modern portfolio theory by showing that investors can realize a higher expected return for a given level of risk (as measured by the standard deviation of return) by adding nondollar bonds in a portfolio containing U.S. bonds. Second, researchers have offered evidence that diversification in nondollar bonds can lead to an optimal choice. However, this evidence comes from earlier studies in the 1980s and early 1990s. Recent research suggests that the reduction in risk may not be that great to offset lower portfolio returns.

There is another reason for investing in nondollar bonds that competes with diversification. For example, a study by Litterman (1992) suggests that while the diversification benefits may not be that great, a powerful reason for a U.S. investor to invest in nondollar bonds is "the increased opportunities to find value that multiple markets provide." However, it is hard to quantify such a benefit because it depends on the investor's talents. That is, nondollar bond investments—with the currency hedged—permits investment strategies based on interest rate changes in various countries. This provides additional dimensions to the actual investment decision or a broader range of investment choices. A final reason given for nondollar bond investing is that the decision not to hedge the currency component can then be regarded as an active currency play.