By Alison Martier
A U.S.-only bond investor is affected by one business cycle, one yield curve and a single monetary policy. As long as rates were falling, that seemed like a good thing. Not so these days.
Going global diversifies an investor's interest-rate risk—and brings many other potential benefits. Although different countries' economic cycles, business cycles, monetary policies and yield curves may briefly align, over long periods they've not been highly correlated. The array of country returns differs significantly each year. And so do future opportunities—and risks. If that sounds worrisome, think again: your own country is part of this mix, and if you've got a home-centric portfolio, it's riding rough seas without ballast.
More Opportunity to Add Value
The most obvious potential benefit to globalizing comes from a significantly increased opportunity set. As of year-end 2012, the Barclays U.S. Aggregate Bond Index comprised $15 trillion in outstanding debt and about 8,000 issues. Its global counterpart, the Barclays Global Aggregate Bond Index, chalked up $39 trillion and more than 14,000 issues. That's a much bigger pond for active managers to fish in.
Even when looking at the historical dispersion of returns among hedged developed-country sovereign bonds, the difference between the best-performing country and the worst is striking. For example, in 2011, hedged sovereign UK bonds outperformed those of both Japan and the euro area by 13.5%.
In most years, the return gap between the best- and worst-performing sectors of the typical U.S. core option—U.S. Treasuries, agencies, mortgages, corporates and other sectors in the U.S. Aggregate, for example—would be just a couple of percentage points. So having such a large gap between country returns provides much more potential opportunity for an active manager to add value.
A Potential Risk Reducer
But that's not the only advantage to globalizing. The historical "up/down capture" of hedged global bond returns compared with U.S. returns is very compelling. We sorted quarterly returns from 1993 through 2012 into periods when the U.S. Aggregate was positive and periods when it was negative. We found that when the U.S. Aggregate was positive, it returned, on average, 2.2%. The hedged Global Aggregate performed almost as well during those same quarters, capturing 95% of that performance. We call that the "up capture."
When the U.S. Aggregate was negative, it returned, on average, –0.9%. While the hedged Global Aggregate was also negative, its "down capture" was just 67%. That's a notable skew. Investors preserved more of their capital during down periods by allocating assets away from the U.S. into countries where rates weren't rising as much, or where they were stable or even declining.
We also looked at this from the perspective of risk mitigation. Using the sovereign bonds of the US, the UK, Germany, Italy and Japan since 1970, we conducted a correlation analysis. Not only could we see that overall correlations were low between non-U.S. debt and U.S. Treasuries (evidence of an ongoing significant diversification benefit), but we could see that during extreme down months for U.S. Treasuries, correlations shrank—in some cases, by two-thirds. That means investors got more risk mitigation from being global when they needed it most.
Hedged Global Bonds: Comparable Return, Less Risk
Adding global is not just a tactical strategy for periods of market drama. Global bonds can serve as a low-volatility anchor to windward—that is, they can meet an investor's core objective. While an unhedged global bond approach fails to fulfill this objective, the overall risk of the global bond portfolio declines sharply once the currency risk is hedged out.
When we compare the three-year rolling standard deviation of the hedged and unhedged global bond approaches as well as U.S. core bonds over the past 20 years, the unhedged global approach (represented by the Barclays Global Aggregate unhedged) has been by far the most volatile series. U.S. bonds (represented by the Barclays U.S. Aggregate) have been much less volatile.
But—drum roll, please—the hedged global approach (represented by the Barclays Global Aggregate hedged to the U.S. dollar) has had the lowest volatility of the three series. Does this volatility translate into lower returns? No. Our analysis examined annualized returns over the same long period we'd used for historical volatility, to see just how well the three approaches—global unhedged, U.S. and global hedged—stacked up (display).
All three fared about the same in terms of raw annualized returns. But the risk-adjusted returns tell the full picture. The Sharpe ratio, which measures return per unit of risk, climbs from global unhedged at 0.6 to U.S. at 0.9 to global hedged at 1.0. Hedged global bonds, in risk-adjusted-return terms, come out the clear winner in the historical data. Global hedged is simply a better way to meet the core objective.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Alison Martier is Senior Portfolio Manager of Fixed Income at AllianceBernstein.