A global bond allocation hedged for currency risk can result in greater risk-adjusted returns than an allocation to local-only bonds, a report says.
An allocation to global bond markets gives investors exposure to a greater number of securities, markets, and economic and inflation environments than they would have with a portfolio composed purely of local market fixed income, according to a research paper from Vanguard.
“In theory, this diversification can help reduce a portfolio’s volatility without necessarily decreasing its total return,” say Todd Schlanger, David J. Walker and Daren R. Roberts, authors of “Going global with bonds: The benefits of a more global fixed income allocation.”
The authors note that this wider exposure might, at first glance, seem to add risk, but they say an investment that includes the bonds of all markets and issuers would theoretically benefit from the greater number of issues, securities, and markets, and their imperfect correlations through time.
In many cases, the differences between markets can be substantial, representing local-market-specific risk factors that can affect a bond portfolio’s performance over time. “For example, a decision to overweight the U.S. bond market is, in effect, a choice to invest less in government bonds and more in corporate and securitized debt. By a similar token, the Canadian bond market is underweight central government bonds and significantly overweight government-related “provincial” bonds. Other overweights and underweights can be found for each local market by corporate sector, maturity, and credit quality,” the paper says.
The authors say, “The important point is that investors should be aware of and consider the impact of these risk factor differences in the context of their portfolio. An investment that, considered in isolation, appears to add risk can actually provide diversification through its interactions with other investments.”
The research found that various local market risk factors (such as interest rates, inflation, and yield curves) have resulted in relatively low correlations of government bond yields across markets over the past 50 years, suggesting a diversification benefit to increasing the number of global markets in a fixed income allocation. “For example, interest rates may be rising in one market and stable or falling in another, the net effect of which can be a dilution of or canceling out of interest rate movements, leading to a more stable return profile. For this reason, a global bond portfolio is typically less sensitive to changes in local interest rates than the weighted average durations of its individual bonds, which come from a wide range of different fixed income markets, would indicate,” the paper says.
The authors stress the importance of hedging global bonds’ currency risk. They explain that investing in global bonds results in exposure to two return streams, one from the underlying bonds and one from the accompanying currency translated back into the investor’s currency. “For example, if a U.K. investor were to purchase a U.S. Treasury bond denominated in U.S. dollars, both the interest payments and the principal repayment would need to be converted from U.S. dollars to British pounds, resulting in an additional return,” they say. “Hedging the currency of global bonds back into the investor’s own currency results in a return stream that is more typical of a high-quality investment-grade bond portfolio.”
The authors explain that the process of hedging currency involves using forward contracts that effectively lock in a set exchange rate based largely on differences in the prevailing interest rates that bring about a forward premium (or discount) to the spot exchange rate. “For example, consider a euro area investor who wants to purchase an Australian bond and hedge this exposure back to the euro. The investor would convert her euros to Australian dollars at the spot rate and purchase the bond. To hedge her Australian dollar exposure, the investor would enter into a forward contract to lock in a forward exchange rate. Often, the forward contract will not be equal to the spot rate, resulting in a forward premium or discount that represents an additional currency return that, combined with the return from the underlying bonds, will make up the investor’s total return.”
According to the report, in practice, currency hedging is implemented over relatively short horizons of between one and three months, resulting in a total-return profile that is similar to what an investor would achieve in her local bond market. The report authors say that historically, these currency returns have been positive in all markets included in their analysis: the United States, Canada, the United Kingdom, France (used as a proxy for the euro area), and Australia.
The authors clarify that when it comes to currency returns from global bonds is that over the long term, the currency returns from hedged and unhedged bonds would likely be similar, due to uncovered interest rate parity. This parity condition holds that interest rate differentials between markets will determine changes in exchange rates, so that the realized rate of return on a risk-free government bond is the same.
The authors say the currency returns from hedged and unhedged global bonds will differ slightly in the long term based on unexpected developments in interest rates and associated currency movements; however, in the shorter term, big gaps between the theory and the reality of uncovered interest rate parity create significant volatility. The research found that regardless of equity/bond asset allocation mix, local market, or currency, hedged global bonds provided risk-reduction benefits relative to leaving the currency risk unhedged. Over the analysis period, the risk-adjusted returns of hedged global bonds were, on average, 3.1 times greater than those of unhedged global bonds.
The authors also discuss in their research report how much unexpected depreciation it would take to justify leaving the currency unhedged; the costs of hedging global currencies; and sizing a hedged global bond investment.