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Global Bonds

 

U.S. investors have traditionally diversified their domestically focused portfolio primarily though the use of international equity funds. Today, however, international bonds make up more than 35% of the world’s investable assets, yet many investors have little or no exposure to them.


Some investors may have sensible reasons for limiting their fixed income exposure to just one country (e.g., for tax considerations). But with the U.S. representing only about 27% of the total global bond market, it makes sense for most investors to look at fixed income investments outside their home country.


In the U.S., fixed income research has demonstrated a reliable relationship between observable credit and term spreads and expected future return differences. More specifically, differences in credit spreads reliably indicate when credit risk is likely to be compensated with higher returns. This holds true in developed foreign fixed income markets as well.


When credit spreads widen, credit risk is expected to outperform on a relative basis; when credit spreads narrow, taking credit risk is less likely to deliver attractive rewards. Investors can use information contained in current credit spreads to design fixed income strategies that dynamically vary exposure to credit risk without any need to predict changes in issuer credit ratings. Predicting credit rating changes is similar to stock picking, and unlikely to consistently add value.


Similarly, current term spreads, or yield curves, contain reliable information about future term rewards. In particular, wider (narrower) term spreads predict larger (smaller) term premiums. Investors can use information contained in the current shape of the yield curve to design fixed income strategies that dynamically vary their exposure to term risk without any need to forecast interest rate changes. Research shows that changes in global interest rates are largely unpredictable and impossible to forecast with enough consistency to produce good results. In other words, an active investment style in international bonds is unlikely to offer consistent long-term rewards.


It’s worth noting that with non-dollar bonds, there is the additional concern of foreign currency exposure. Efficient market research conducted on exchange rates found the same “random walk” phenomenon as with the stock market. Exchange rates move unpredictably. Currency exposure clearly increases the volatility of the fixed income portfolio (See the table that follows).


(1/85 – 12/11)

Fixed Income Strategies

Annualized

Citi Group Global

Hedged

Citi Group Global

Un-Hedged

Barclays U.S.

Govt/Credit

Index

 

 

 

 

Standard Deviation (%)

3.66

7.44

4.69

Returns (%)

7.24

9.87

7.95

Maturity (Years)

1-30

1-30

1-30


Incorporating un-hedged foreign bonds into a portfolio may improve fixed income portfolio returns. But because currency exchange rates are more volatile than the broad U.S. bond market, the currency exposure inherent in un-hedged international bonds is likely to negate any diversification benefit that otherwise may be expected.


By hedging currency exposure, the investment return is tied to the performance of the underlying asset class alone. With currency exposure hedged away, international bonds assume a return profile that is more bond-like and the volatility of the portfolio (as measured by the standard deviation) is decreased. As the table shows, moving from a U.S. strategy to a global hedged strategy with full market coverage leads to a significant reduction in volatility. The standard deviation decreases from 4.69% to 3.66%, and outweighs any loss in annualized return (7.95% for the U.S. strategy versus 7.24% for the static global strategy).


One recent study by Dimensional Fund Advisors (DFA) explores the tradeoff between volatility reduction and expected return as market coverage is adjusted. In the DFA study, researchers first expanded the number of countries to add diversification, which reduced the volatility of the portfolio. They then gave up 50% of the global market capitalization to increase returns almost 85 basis points by investing only in those countries with the highest expected returns, as represented by the steepest yield curves.


Vanguard recommends that investors consider allocations to hedged international bonds for diversification purposes. For the average investor seeking to minimize volatility in a diversified portfolio, they suggest a 20% to 40% allocation to international bonds within the fixed income portfolio. This provides a reasonable balance between diversification and cost and assumes that the currency risk inherent in the asset class is hedged.


Hedged foreign bonds take advantage of imperfect correlations among developed bond markets, offering a variety of potential benefits. Investors in hedge foreign bonds are no longer subject to the risk of one bond market or to the expected returns of just one yield curve. Thus, adding foreign currency hedged bonds to a portfolio that also contains domestic bonds creates a more diversified fixed income portfolio. Global bond portfolios are often more well suited than their domestic counterparts to reduce portfolio volatility, which is the primary goal of fixed income investing. And given the global nature of highly-rated debt issuers, international diversification can be achieved without sacrificing the credit standards of domestic bond portfolios.


What about the role of un-hedged bonds? The last 25 years were characterized by long-term depreciation of the U.S. dollar. That is why un-hedged international bonds out-performed hedged bonds by 2.6 percentage points per year on average. Since un-hedged bonds heighten portfolio volatility and suggest a bearish view on the U.S. dollar, investors need to ask themselves if they believe the U.S. dollar will remain on a long-term downward trend, with depreciation countering the higher volatility.


Though there is evidence that structural differences in price levels and trade flows between countries can force currencies to a fundamental equilibrium in the long run, the expected changes in currencies are already priced into the money markets. As a result, any allocation to un-hedged international bonds that is driven by views on potential currency returns should be considered with care. Yet investors who are willing to take on additional risk and wishing to position their portfolios for the possibility of such extreme unexpected dollar depreciation may consider using un-hedged international bonds for a portion of their fixed income allocation.