Going global with bonds: Considerations for UK investors
08 January 2014 | Asset classes
Global bonds allow investors to achieve exposure to the interest rate profile, economic cycles and political climate of a wide range of markets outside of the United Kingdom. Some of these may seem to add unnecessary risk to a portfolio, given the overall stability of the UK and the relative quality of the debt issued by its government and UK corporations. But rather than looking at the risk of individual securities investors should consider how global bonds can help them diversify their fixed income allocation. To the extent that the events influencing global markets differ from those that drive the UK market, global bonds can be a sensible addition to many investors’ portfolios.
The global bond market - as a whole – indeed exhibits a meaningfully different risk profile from the UK market; in other words, global bonds and UK bonds are not perfectly correlated and may go in different directions at certain times. What matters is not so much how risky a particular investment is in isolation but how much risk it adds to a portfolio. Taking into consideration how they interact, adding global bonds to a UK fixed income portfolio can actually allow investors to reduce risk without necessarily decreasing the expected return.
Investors may also find it interesting to look at the market composition. The UK market differs from the global market in several ways. Longer-term issues with higher duration and, consequently, higher interest rate sensitivity are more prominent in the UK relative to the rest of the world. The UK is also largely dominated by central government bonds and corporate issues but lacks exposure to securitised debt. The corporate sector is biased towards Aaa-rated issues and underweight in Aa bonds relative to the global market. All else being equal, this means that investors with a significant UK-home bias take on less credit risk than the global market as a whole, potentially giving up yield as a result, which may or may not align to their original objectives.
What about currency risk?
Currency risk represents a particular challenge to fixed income investors going abroad. A foreign currency can, of course, increase in value, thus enhancing the return on an investment. But the merits of currency are generally less straightforward: it doesn’t generate cash flows, and research suggests that short-term currency movements follow a random walk, making them nearly impossible to predict. As such, currency seems to provide no value to investors but is a source of volatility. Indeed, in our analysis we find that for un-hedged bonds to appear as a viable investment, investors need to assume an unrealistically high unexpected currency return. Investors can, however, hedge the currency risk through forward contracts. With hedging costs amounting to roughly four basis points* in 2012, a negligible amount compared to the average TER of 1.3% for actively managed global bond funds available in the UK, the cost of hedging is relatively insignificant in light of the benefits it can bring.
Why not go global?
Some institutions such as defined benefit pension funds or insurance companies might opt against global diversification and stick to a sterling exposure for liability matching purposes. These investors naturally wish to buy bonds that match both the duration and the currency of their liabilities. But, even for investors who track a particular liability or wish to fund future consumption in sterling, a global bond allocation can make sense since hedging the currency exposure allows them to some extent to maintain a global bond allocation and a local interest rate profile at the same time.
In 2010, the average UK fixed income investor had 57% of their portfolio invested in UK bonds, implying a 51% ‘over-weight’ relative to the global bond market. Our analysis calls this overweight into question. With currency hedged back to sterling, the global fixed income market can allow investors to expand their opportunity set and benefit from increased diversification. With the UK market representing a small, concentrated portion of the world’s fixed income securities, we would encourage investors to consider how a global bond allocation may help them meet their investment objectives.
If you would like to know more about global bonds, you can find the full research report here.
*Annualised, based on the current weights in the global aggregate
This material is aimed at professional investors and should not be relied upon by retail investors."
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested."
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.