This paper assesses the incremental diversification benefits to US investors from investing in international government bonds. In light of suggestions that these benefits have fallen sharply in the recent decade due to more closely synchronized business cycles, we use mean-variance spanning tests to show that currency-hedged bonds provide significant diversification benefits over the period from January 1992 to September 2002. Using a bivariate GARCH framework, we find that US bond returns have become increasingly correlated with UK and German bond returns, but have experienced declining correlations with Japanese bonds. The changing correlations are consistent with variation in the synchronization of business cycles. However, the evidence suggests that correlations have not become high enough to threaten the gains from diversification and that these gains on a currency-hedged basis are not diminished during periods of weakness or increased volatility in US or foreign bond markets. Conditional Sharpe ratios also demonstrate that risk-reward tradeoffs for each bond market vary in a predictable manner, which further underscores the potential benefits of international bond investing. Finally, we demonstrate how conditional yield betas and conditional yield beta adjusted foreign bond durations can be constructed from our model estimates.

We investigate the incremental role of emerging market debt and corporate bonds in internationally diversified government bond portfolios. Contrary to earlier results, we find that international diversification among government bonds does not yield significant diversification benefits. This result is obtained using mean-variance spanning and intersection tests, with restrictions for short sales, both for currency unhedged and hedged international developed market government bonds. Currency hedged international corporate bonds in turn do offer some diversification benefits, and emerging market debt in particular significantly shifts the mean-variance frontier for a developed market investor. Since especially unconstrained mean-variance spanning and intersection tests can indicate significant diversification benefits, but lead to frontier portfolios with extreme weights, we also consider some ex-ante global government bond portfolio strategies. We find that passive global benchmarks such as GDP-weighed government bond portfolios perform quite well within developed countries.

investors generally experience diversification benefits by adding foreign bonds to their domestic bond portfolio. Further, financial integration is found to increase within the largest developed countries. Diversification benefits are most for the last two year of the study period when short sales are allowed, where it is believed that the financial crisis has not fully reach emerging markets and small economies like Denmark.