More and more, global bonds are being used as core portfolios for investors seeking an anchor to windward for their stock investments. While this is generally a good thing, some investors are discovering that the decision to go global can have unintended consequences: certain global bond portfolios have much higher volatility than is usually associated with core portfolios.
Bonds generally have two main sources of return: income (the return from coupon payments) and price (return from capital appreciation). Most of a bond's return usually comes from income, which is a very stable source of returns. A smaller contribution comes from prices changes. This component is smaller, since, unlike equities, bonds have limited upside; they mature at par.
Global bonds add an additional source of potential returns: currency exposure. Currency hedging—which can be implemented simply and cheaply with currency forwards or futures—eliminates the impact of currency changes on bond returns. Nonetheless, many investors choose not to hedge, in the hope that currency exposure can boost returns. They also assume that multiple sources of return will reduce their overall risk. It turns out, though, that neither of these assumptions is correct.
Between 1996 and 2011, a US dollar-hedged global bond portfolio, represented by the
Barclays Capital Global Aggregate Bond Index, would have generated nearly identical returns to an unhedged portfolio— 5.9% versus 5.8% annualized. This may come as a surprise to many investors, given the decline we've seen in the US dollar.
Furthermore, although currency exposure represented the additional source of potential return, it didn't reduce volatility, as you might expect. As the display below shows, currency-hedged global bonds have been consistently much less volatile than unhedged global bonds, and even less volatile than US bonds, due to the benefits of economic cycle diversification.
This is such a striking result that it bears repeating: hedged global bonds have delivered similar returns to unhedged bonds, but with dramatically lower volatility. How could this be?
While currency exposure has added nothing to global bond returns over the past 16 years, it contributes around two thirds of the overall volatility, as the display below shows. This implies that currency, in and of itself, is about twice as risky as fixed income.
The lesson here is that not all global bond portfolios are cut from the same cloth. Some, with currency hedging, are suitable as low-risk core portfolios while others are higher volatility, and are more suitable for investors seeking higher-risk investments. And indeed, investors in some parts of the world have traditionally used global bonds primarily as a means to gain foreign currency exposure. That may be appropriate, but in this case they shouldn't view their global bond exposure as the stability element in their overall asset allocation.
For those investors seeking to use global bonds as a stable anchor to windward in place of local bonds, the evidence is clear: currency hedging should be the default position.
Douglas J. Peebles is head of fixed-income at AllianceBernstein.
