The Nobel Prize-winning economist Harry Markowitz famously described diversification as “the only free lunch in finance” – and the reason is simple. A diversified investor can potentially gain higher risk-adjusted returns by investing in several assets or markets at once.
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 diversification benefits of global bonds.
Why diversification matters
While bonds traditionally provide more consistent returns than many other assets, they still tend to be affected by the economic cycle. But a global bond portfolio is typically less sensitive to changes in local interest rates than the weighted average durations of its individual bonds.
Diversification across different bond markets can also offer more varied exposures in terms of sectors, issuers, maturities and credit quality – for example, investors can usually 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 opens up deeper pools of liquidity for investors too; 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 improve portfolio returns, translating those returns into an investor’s home 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 similar to that of a high-quality investment-grade bond portfolio.
The process of hedging locks in a certain amount of currency return, which can be either positive or negative. It is true that, over the long term, 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 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 unhedged (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.)
Risk-adjusted returns are what count
One way to measure this trade-off between volatility and returns is to look at risk-adjusted returns. This casts currency in an unfavourable light, which is not surprising given the long-term expected return from currency is virtually zero while it adds significantly to portfolio volatility. Indeed, the above research found that, on average, the risk-adjusted returns of hedged global bonds are more than three times those of unhedged bonds.
For portfolio constructors, it is crucial to consider this difference 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. But if bonds are to retain this function in a global portfolio, currency hedging is critical. We found that hedged developed market global bonds tended to provide more consistent returns and, in many cases, better downside protection than both their unhedged equivalent and local bonds.
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, using data covering the period from 1 January 1992 to 30 June 2017. We found that, apart from a spike during the global financial crisis of 2008/09, these hedging costs declined over time, particularly in sterling, Canadian dollars and euros. This suggests the minimal drag on returns from hedging is a price worth paying for the significant diversification benefits that can be achieved from a global bond portfolio.
We appreciate not all investors will want to move away completely from their home bond market. Some will have certain liabilities they are seeking to meet from their portfolio. For others, 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.
Giulio Renzi-Ricci, senior investment strategist, Vanguard Europe
