Just like diversifying a stock portfolio across different borders, going global with bonds can provide lower correlations and raise prospects for greater long-term returns.

That might sound contrary to what some advisers are saying these days. In 2008, critics of the benefits of diversification came out of the woodwork as correlations among most major asset classes collided to 1. 

However, a wealth of academic and real-world evidence strongly suggests that country- or region-specific events causing downturns can be softened by global diversification in stock portfolios.

It just stands to reason that as the ongoing credit crisis unwinds, investors should be able to reap long-term benefits from diversifying their debt portfolios as well. 

The exchange-traded funds industry certainly has heard the call for international bonds. Despite difficulty in accessing some of these markets, the low-correlation benefits when compared to U.S. Treasuries are making these types of funds attractive to sponsors—in terms of providing more tools for long-term individual investors as well as institutions.

This year, iShares issued two international Treasury bond ETFs, tracking indexes covering Treasury bond issues from developed countries around the world excluding the U.S. Those are the S&P/Citigroup International Treasury Bond Fund (Nasdaq: IGOV) and the S&P/Citigroup 1-3 Year International Treasury Bond Fund (Nasdaq: ISHG).

State Street Global Advisors has a similar ETF lineup in the international developed sovereign debt space with the SPDR Barclays Capital International Treasury Bond ETF (NYSEArca: BWX) and the SPDR Barclays Capital Short Term International Treasury Bond ETF (NYSEArca: BWZ).

Globally Diversifying Bonds

International Treasury bonds of developed countries have very little credit risk; however, the risk of default is not zero, and sovereign risks of each country should be taken into account. Paul Amery wrote on the increasing default risks in European countries as seen through the five-year spread in credit default securities. (See the story, "Sovereign Default Risks On The Rise.")

Using international bonds in a portfolio can add diversification by spreading out the sensitivity of U.S. interest rate movements which affect bond prices. International governments will have different monetary policies and interest rates that will affect that government's Treasury bond prices differently.

Currency Considerations

International treasury bonds included in these ETFs are issued in local currency, unlike some emerging market bond ETFs that include only developing country government issued debt in the U.S. dollar.

The chart below displays U.S. Treasury annual returns versus global Treasuries in developed markets. Representing U.S. Treasuries is the Morningstar U.S. Treasury Bond Index, which includes U.S. Treasuries with maturities greater than one year and $1 billion outstanding.

Global Treasuries are represented by the Morningstar Global ex-U.S. Government Bond Index, which is similar to the makeup of the international ETF's respective indexes. There is also a variation to the index that hedges the currency fluctuations and makes an interesting illustration.

Looking at the gap between the U.S. dollar un-hedged and hedged Global Government Bond Indexes shows the effect currency has played in the annual returns in the past within this category.

In most years, outside of first quarter 2009 and 2005, currency, or the difference between the unhedged and hedge indexes, benefited the U.S. investor.

Currency exchange movements are hard to predict, and the pattern of a falling U.S. dollar to other major currencies which has caused many foreign assets to outperform comparable U.S. assets may not continue in the future. Investor need to be aware that currencies seem to be a major driver of returns in the above chart, and potentially for the ETFs that cover this asset class.

Using the same indexes from the above chart, correlations show how significant the diversification effect would be for an investor adding international developed Treasury bonds to a portfolio of U.S. Treasuries. According to Morningstar, the correlation of return between the hedged index (without currency fluctuations) and U.S. Treasuries was .81 over the last five years. Currency seemed to significantly lower the correlation in both cases.

The Indexes

The two S&P/Citigroup indexes that make up the S&P/Citigroup International Treasury Bond Index Series are designed to track treasury bonds in developed countries, excluding the U.S. The index defines a developed country as classified by the Bank for International Settlements (BIS). IGOV's tracking benchmark is the S&P/Citigroup international Treasury Bond ex-Us Index, which tracks foreign Treasury bonds with maturities greater than one year, while ISHG's index, the S&P/Citigroup International Treasury Bond 1-3 Year Index, is similar in most ways, but limits the bond holding to maturities greater than one year and less than three.

Both indexes in the series weight countries based on a market value, similar to a market-cap weighting in equities, but with some constraints. Countries within the index are limited to a 24.95% holding by the index, and the sum of country weights above 4.95% cannot be greater than 50% of the index.

The indexes rebalance monthly to reweight according to country guidelines set annually in March of each year. Bonds within the countries are weighted similarly to the way the country weights are set within the indexes, by market value.

Since there is some overlap in holdings of the two S&P/Citigroup bond indexes, the country weights tend to mirror each other. The annual reweighting took place this March and the S&P committee did not add or remove any country. Noteworthy is the Japanese portion of the 19 countries included in the indexes, which was the maximum allowance in both the 1-3 year and intermediate index.

The indexes which are tracked by the SPDR ETFs, (NYSEArca: BWX) and (NYSEArca: BWZ), have a methodology similar to S&P/Citigroup. The Barclays Capital (formerly Lehman Brother) indexes include these developed countries: Australia, Austria, Belgium, Canada, Denmark, France, Germany, Greece, Italy, Japan, Mexico, Netherlands, Poland, South Africa, Spain, Sweden, Taiwan, and United Kingdom. The country weights are designated based on a market value approach similar to market capitalization. The bonds within each country are done likewise, with higher weighting given to higher market value.

The index will rebalance monthly based on the rules of inclusion. If a country or holding fails to meet the inclusion rules, it will be excluded from the index.

The two indexes have the same methodology, with one exception: The Barclays Capital Global Treasury ex-US 1-3 Year Capped Index, tracked by BWZ, only includes bonds with maturities more than one year but less than three.

The countries included in the index have credit qualities that are considered investment grade, using a middle credit rating from the three credit rating agencies. Some of the countries included in the indexes that meet the investment-grade requirements are included in developing country indexes like Mexico and South Africa.

The ETFs

For all for of the ETFs, Japan seems to make up a large percentage of each ETF. BWX, as of April 30, held 22.65% Japanese government bonds, and IGOV, as of the same date, held 24.61% but will be rebalanced each month, reweighting the Japanese holding to its maximum allowance of 24.95%.

The methodologies of the funds are mostly to blame for the funds' holdings shifting largely to Japan. Unlike stock indexes where the market participants fundamentally decide the total market value or market capitalization of a company's stock or basket of stocks, the total market value of bonds can be influenced heavily by the by the issuer, issuing more bonds.

Cost is a factor with higher quality fixed-income vehicles, since expected return and yield are lower. The chart below shows the expense ratios for the four developed international bond ETFs.

IGOV appears to track country weights, and sample from the bond holdings within each country. This sampling allows for an easier basket of bonds to create and redeem shares of the ETF, while keeping credit quality closely mirroring the index. As of the end of the first quarter in 2009, IGOV held 47 bond issues, while the underlying index held 552.

Kyle Waller is a research analyst at Wiser Wealth Management in Marietta, Ga. He welcomes comments and suggestions for future columns at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .