International fixed income: The investment case FOR EXISTING VANGUARD ADVICE CLIENT USE ONLY. NOT FOR DISTRIBUTION

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1 International fixed income: The investment case

2 Why international fixed income? International bonds currently make up the largest segment of the securities market Ever-increasing globalization and access to information has led to increased investor acceptance regarding international investing Concern regarding the future of the U.S. economy and financial markets Additional diversification benefits Global capital markets 33% International bonds 24% International equities 22% U.S. bonds 21% U.S. equities Sources: MSCI, Barclays Capital, and Vanguard, as of December 31, U.S. equities are represented by the MSCI US Broad Market Index. International equities are represented by the MSCI AC World Ex USA IMI. U.S. bonds are represented by the Barclays Capital US Aggregate Bond Index. International bonds are represented by the Barclays Capital Global Aggregate ex-usd Index. 2

3 Key drivers of returns imply global diversification benefits Correlations of yields and inflation in the largest international markets versus the United States, Belgium Canada France Germany Italy Japan Netherlands Spain U.K. Correlation of changes in foreign inflation rates to U.S. inflation rates Correlation of changes in foreign long bond yields to U.S. bond yields Sources: U.S. Federal Reserve, U.S. Bureau of Labor Statistics, various international government agencies via Thomson Reuters Datastream, and Vanguard. 3

4 Yet adding unhedged foreign bonds has increased portfolio volatility Annual volatility of a portfolio starting at 100% U.S. bonds 12% 10% Annual volatility 8% 6% 4% 2% 0% 0% 20% 40% 60% 80% 100% Percentage of portfolio in international bonds Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. All benchmarks in this and subsequent slides do not have real-world operating, trading, or hedging costs. The use of index funds or ETFs in any investment strategy will have differing results because of differences in management costs, tracking error, and other factors. Sources: MSCI, Barclays Capital, Citigroup, and Vanguard.Data from 1985 to December 31, U.S. equities are represented by Dow Jones U.S. Total Stock Market Index from 1975 through April 22, 2005, and the MSCI US Broad Market Index thereafter. International equities represented by MSCI World Ex USA Index through 1987, MSCI AC World Ex USA Index from 1/1/1988 to 4/30/1994, and MSCI AC World Ex USA IMI thereafter. U.S bonds represented by Barclays Capital US Aggregate Bond Index. International bonds represented by Citigroup World Government Bond Ex-US Index through 1989 and Barclays Capital Global Aggregate ex-usd Bond Index thereafter. 4

5 And not improved downside risk Worst 12 months for portfolio starting at 100% U.S. bonds 0% -2% -month return % -6% -8% -10% -12% 0% 20% 40% 60% 80% 100% Percentage of portfolio in international bonds Sources: MSCI, Barclays Capital, Citigroup, and Vanguard. Data from 1985 to December 31, U.S. equities are represented by Dow Jones U.S. Total Stock Market Index from 1975 through April 22, 2005, and the MSCI US Broad Market Index thereafter. International stocks represented by MSCI World Ex USA Index through 1987, MSCI AC World Ex USA Index from 1/1/1988 to 4/30/1994, and MSCI AC World Ex USA IMI thereafter. U.S bonds represented by Barclays Capital US Aggregate Bond Index. International bonds represented by Citigroup World Government Bond Ex-US Index through 1989 and Barclays Capital Global Aggregate ex-usd Bond Index thereafter. 5

6 Unhedged foreign bonds did not help during the global flight to quality Total return: March 2008 February % 2% 0% -2% -4% -6% -8% -10% -12% U.S. bonds International bonds Currency exposure Sources: Barclays Capital, Citigroup, and Vanguard. U.S bonds represented by Barclays Capital US Aggregate Bond Index. International bonds represented by Citigroup World Government Bond Index Ex US through 1989 and Barclays Capital Global Aggregate ex-usd Index thereafter. 6

7 Volatility significantly dampened by hedging currency exposure 70% 60% 12-month rolling return 50% 40% 30% 20% 10% 0% -10% -20% Hedged international bonds Unhedged international bonds Sources: Thomson Reuters Datastream, Barclays Capital, Citigroup, and Vanguard, as of December 31, Hedged international bonds are represented by the Citigroup World Government Bond Ex-US Hedged Index through 1989 and the Barclays Capital Global Aggregate ex-usd Hedged Index thereafter. Unhedged international bonds are represented by the Citigroup World Government Bond Ex-US Index through 1989 and the Barclays Capital Global Aggregate ex-usd Index thereafter. U.S. bonds are represented by the Barclays Capital U.S. Aggregate Bond Index. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 7

8 Diversification benefits show up with hedged foreign bonds Annual volatility of a portfolio starting at 100% U.S. bonds 5% 4% 57 bps volatility reduction Annual volatility 3% 2% 1% 0% 0% 20% 40% 60% 80% 100% Percentage of portfolio in hedged international bonds Sources: MSCI, Barclays Capital, Citigroup, and Vanguard. Data from 1985 to December 31, U.S. equities are represented by Dow Jones U.S. Total Stock Market Index from 1975 through April 22, 2005, and the MSCI US Broad Market Index thereafter. International stocks represented by MSCI World Ex USA Index through 1987, MSCI AC World Ex USA Index from 1/1/1988 to 4/30/1994, and MSCI AC World Ex USA IMI thereafter. U.S bonds represented by Barclays Capital US Aggregate Bond Index. International bonds represented by Citigroup World Government Bond Ex-US Hedged Index through 1989 and Barclays Capital Global Aggregate ex-usd Hedged Bond Index thereafter. 8

9 And downside risk improved Worst 12 months for portfolio startingat 100% U.S. bonds 0% -1% 12-month return -2% -3% -4% -5% 0% 20% 40% 60% 80% 100% Percentage of portfolio in hedged international bonds Sources: MSCI, Barclays Capital, Citigroup, and Vanguard. Data from 1985 to December 31, U.S. equities are represented by Dow Jones U.S. Total Stock Market Index from 1975 through April 22, 2005, and the MSCI US Broad Market Index thereafter. International stocks represented by MSCI World Ex USA Index through 1987, MSCI AC World Ex USA Index from 1/1/1988 to 4/30/1994, and MSCI AC World Ex USA IMI thereafter. U.S bonds represented by Barclays Capital US Aggregate Bond Index. International bonds represented by Citigroup World Government Bond Ex-US Hedged Index through 1989 and Barclays Capital Global Aggregate ex-usd Hedged Bond Index thereafter. 9

10 Why hedge bonds and not stocks? Annualized return and volatility, International stocks return International stocks volatility International bonds returns International bonds volatility Local contribution Currency contribution Sources: Thomson Reuters Datastream, Barclays Capital, Citigroup, Dow Jones, MSCI, and Vanguard. Notes: International stocks are represented by the MSCI World ex-us Index from 1985 to1989 and the MSCI All Country World ex-us Index thereafter. International bonds are represented by the Citigroup World Government Bond ex-us index from 1985 to 1989 and the Barclay s Capital Global Aggregate ex-usd Index thereafter. 10

11 But what about long-term returns? Total return: January 1985 December % 9.40% 8% 7.88% 7.17% 6% 4% 2% 0% U.S. bonds International bonds currency exposure International bonds no currency exposure Sources: Barclays Capital, Citigroup, and Vanguard. Data from 1985 to December 31, U.S bonds represented by Barclays Capital US Aggregate Bond Index. International bonds represented by Citigroup World Government Bond Index Ex US through 1989 and Barclays Capital Global Aggregate ex-usd Index thereafter. 11

12 Why now? Currency hedging costs have declined nearly 50% since the early 2000s Bid-ask spread on 1-month currency forward 0.40% 0.30% 0.20% 0.10% 0.00% Australian dollar Canadian dollar Euro Yen Swiss franc British pound Weighted average hedging cost Sources: Thomson Reuters Datastream, Barclays Capital, and Vanguard, as of December 31, We used the annualized bid-ask spread on a 1-month currency forward contract as a proxy for the cost of implementing a constant rolling hedge for each individual currency. In practice, 3- or 6-month forward may be used. The weighted average hedging cost is approximated by combining the currency forwards according to the historical market weight of the outstanding debt of each entity. 12

13 Summary and key takeaways Single largest asset class International bonds are expected to provide diversification benefits Hedged foreign bonds lower portfolio volatility and downside risk, providing exposure to global bonds without adding currency risk Falling costs of hedging international bonds makes a global bond allocation more attractive 13

14 Important information All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. Investments in stocks or bonds issued by non-u.s. companies are subject to risks including country/regional risk and currency risk. Bonds of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets. Diversification does not ensure a profit or protect against a loss The Vanguard Group, Inc. All rights reserved. 14

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