Why currency hedging can help to unlock the benefits of global bonds
21 September 2020 | Portfolio construction
Diversification was once famously described as “the only free lunch in finance”1. The reason is that a diversified investor can potentially gain higher risk-adjusted returns by investing in several assets or markets at once. It’s not that hard to see why. Being exposed to a wide range of securities and countries gives investors access to a much wider range of influences, while reducing their exposure to the risks of any one in particular. This applies to bonds as much as any other asset. What is often forgotten is the importance of currency. Failure to deal with fluctuations in exchange rates can nullify many of the benefits of diversification from an allocation to global bonds.
Why diversification matters
Bonds traditionally provide more consistent returns than many other assets, but they still tend to be affected by the economic cycle. However, a global bond portfolio is typically less sensitive to changes in local interest rates than the weighted average durations of its individual bonds.
In addition to different economic cycles, bond markets in different countries offer more varied exposures in terms of sectors, issuers, maturities and credit quality. For example, a European investor can gain access to a wider range of corporate bonds of higher quality and at longer maturities than is available in their home market. Global diversification also opens up deeper pools of liquidity for investors. In government bonds, going global can give non-US investors access to the US Treasury market – the world’s deepest and most liquid bond market.
Currency can kill returns
Unfortunately, no lunch is entirely free. While diversification can help improve portfolio returns, translating those returns into an investor’s own currency can introduce volatility. Currency movements tend to deviate from where theory tells us they should be over the short to medium term. This can significantly raise the volatility of returns from foreign bonds. By hedging back to an investor’s own currency, the stream of returns becomes more typical of that from a high-quality investment-grade bond portfolio, as the chart below illustrates.
Currency can significantly affect global bond returns through time
Past performance is not a reliable indicator of future results. These performance figures are calculated in US dollars, Canadian dollars, euros and Australian dollars and the return may increase or decrease as a result of currency fluctuations.
Notes: Data cover 1 February 1999 to 30 June 2017. The returns shown are represented by the monthly total returns of the Bloomberg Barclays Global Aggregate Bond Index in various currencies. For illustrative purposes, the hedged global bond return represents the hedged return from the perspective of a US dollar investor; in practice, returns hedged to other currencies will differ slightly by the amount of the “currency return”, as discussed later in this article.
Sources: Vanguard calculations, using data from Macrobond.
The process of hedging does itself lock in a certain amount of currency return, which can be either positive or negative. It is true that, over the long term, theory dictates that currency returns from unhedged portfolios are likely to be similar to those from hedged portfolios – and could be even greater if the investor’s local currency depreciates faster than expected. However, our research suggests that the benefits of reducing short- to medium-term volatility through hedging more than make up for any additional returns that might reasonably be expected to be garnered from leaving global bonds unhedged2.
Returns adjusted for risk is what counts
One way to measure this trade-off between volatility and returns is to look at returns in risk-adjusted terms. This analysis tends to cast currency in an unfavourable light, which is not surprising given that the long-term expected return from currency is virtually zero while, as we have seen, it adds significantly to portfolio volatility. Indeed, we found that, on average, the risk-adjusted returns of hedged global bonds are more than three times those of unhedged bonds2.
This is important for portfolio constructors to bear in mind, because the difference becomes crucial in a portfolio context. Traditionally, a key role of high-quality investment-grade bonds is in providing stability at times when more volatile assets, like equities, are falling. Our research suggests that currency hedging is critical if bonds are to retain this function in a global portfolio. We compared hedged developed-market global bonds against both their unhedged equivalent and local bonds and found that they tended to provide more consistent returns and, in many cases, better downside protection.
Of course, hedging is not itself free. As an approximation of the costs, we looked at the bid-ask spread of forward contracts used to hedge six major currencies in dollars.3 We found that, apart from a spike during the global financial crisis in 2008-2009, these hedging costs declined over time, particularly in sterling, Canadian dollars and euros. This suggests that the minimal drag on returns from hedging is still a price worth paying for the significant diversification benefits that can be achieved from a global bond portfolio.
We realise that not all investors will want to move away completely from their home bond market. Issues to consider will include the liabilities they are seeking to meet from their portfolio. For some investors, a portion of duration-matched local assets may be more suitable and better able to comply with local regulatory requirements.
Nonetheless, even small allocations to global bonds can make a difference to reducing volatility without necessarily compromising returns. The key to getting the best out of any such diversification is for the investor to hedge back to their own currency. Vanguard’s global bond index funds are mostly hedged back to the fund’s base currency, although we do offer some unhedged share classes for clients who may have specific goals or objectives.
1 By Professor Harry Markowitz, a Nobel prize-winner for economics who is often known as the father of modern portfolio theory.
2 Source: Schlanger, Todd, David J. Walker and Daren R. Roberts, 2018, “Going global with bonds: The benefits of a more global fixed income allocation”, Valley Forge, Pa.: The Vanguard Group..
3 Data covered period from 1 January 1992 to 30 June 2017.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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