What to know about adding foreign bond exposure to your portfolio

Investors have been raking in income thanks to attractive yields in the U.S. bond market. Yet, some portfolio managers also believe it’s a good time to look outside a home market to diversify a portfolio. One of those who likes foreign credit is Rick Rieder, BlackRock’s chief investment officer of global fixed income. His BlackRock Flexible Income ETF (BINC) has a 5.57% 30-day SEC yield and holds assets in Europe, the U.K. and emerging markets. Investment grade corporate bonds make up about 19% of BINC, with approximately half of those in European names. “This is a pretty extraordinary point in time where not only can you buy growth in the equity market, you can build a lot of income in a portfolio and you don’t have to take a lot of risk,” Rieder said in a late March interview on CNBC’s ” Power Lunch .” BINC YTD mountain BlackRock Flexible Income ETF year to date. High yield accounts for 35% of the portfolio, with about 20% of the assets in U.S. bonds and 15% in Europe and the U.K. Rieder likes high-yield European bonds given the strength of the U.S. dollar. That currency translation gives the bonds additional yield, he said. Another reason Rieder likes bonds issued in the 27-nation European Union is because he expects the European Central Bank to move faster than the Federal Reserve in lowering interest rates thanks to slow growth on the continent and a faster decline in inflation. “I think rates will come down, and the credit quality is very good,” Rieder said in a phone interview. Within emerging markets, which make up about 6% of the portfolio, Rieder prefers higher-quality bonds, with yields up to 12%, from issuers in Mexico and Brazil, among others. Determining allocations Before jumping into non-U.S. bonds, first determine if you already have foreign exposure, such as within a target date fund and, if so, how much. “A lot of individual investors tend to be under-allocated to international bonds,” said Collin Martin, fixed income strategist at Schwab Center for Financial Research. While he thinks investors should own some global bonds, he recommends keeping the allocation to both developed market and emerging market non-U.S. debt to a total of 10% or less of a portfolio. Right now, Martin is neutral on developed market bonds. U.S. bond yields are generally higher than global yields and there is currency risk abroad, he said. However, Martin thinks emerging market debt looks relatively attractive, with a yield advantage over the U.S. by often paying out 6% or 7%. Emerging market issuers offer bonds denominated in both U.S. dollars and local currencies. “We favor local currency bonds right now,” he said. “They have relatively high yields and we think emerging market currencies can hold their value or maybe even increase a little bit given the global economic resilience we have seen.” The strength of the global economy tends to affect emerging markets more so than developed countries since they tend to be more sensitive to exports and commodity prices, Martin noted. It’s not all sunshine and flowers, though. Investors also have to be aware that there is a greater risk of default in emerging market countries. “Emerging markets over time will likely get higher returns there, but with those higher returns comes a lot of volatility,” Martin said. Investing in global bond funds Individual investors can add exposure to foreign bonds through global bond funds. There are hedged funds, which hedge foreign currency exposure back to the U.S. dollar and therefore reduce currency risk. The other option is unhedged funds, some of whose portfolio is in foreign bonds issued in local currencies. “Currency can add a lot of volatility to your bond portfolio,” said Mike Mulach, senior manager research analyst at Morningstar. Over the past 20 years, investing in a fund that hedged its non-U.S. dollar exposure outperformed investing in a fund that didn’t, he said. “Currency risk is real. It could be a huge problem,” Mulach said. “It can also be good and can also add a lot of value as well, at times.” There are a lot of different approaches to overseas debt investing, so pay attention to the duration and sector exposure, he added. ( Duration is a measure of a bond or entire portfolio’s sensitivity to interest rates, and usually rises the farther out the maturity date.) Also understand how much emerging-market debt is included, Mulach said. “It’s good to be diversified because foreign bond exposure is a massive part of the global bond markets,” Mulach said. Here are Morningstar’s top picks for global bond exposure: The Pimco strategies keep the bulk of their non-U.S. currency exposure hedged back to the U.S. dollar. However, the firm almost always puts on small, tactical currency bets, the Morningstar analyst said. Both are five-star, silver-rated by Morningstar. The institutional shares, which are available for institutional investors such as retirement benefit plans, are rated gold. Meanwhile, BlackRock’s Strategic Global Bond Fund is also one of Rick Rieder’s funds. Investor shares are rated four stars and silver by Morningstar. Dodge & Cox’s Global Bond Fund (DODLX) garners five stars and a gold rating. — With additional reporting from CNBC’s Darla Mercado