By Scott DiMaggio and Alison Martier
More investors than ever are looking to jump into the global bond boat - as they well should. But will they get the safety-oriented core bond mandate they expect, or a high-volatility, white-water experience?
Investors can get beaten up when their portfolio behaves in unexpected ways. Here are four crucial guidelines we think investors should review with their managers in order to ensure their global core solution is both truly global and truly core.
What's in a Name?
For starters, global bond portfolios should derive their alpha, or return premium versus the benchmark, from globally diversified sources. It seems surprising, but not every bond portfolio that calls itself global is actually global. Some concentrate significantly in certain countries or regions.
Countries' bond returns differ greatly from year to year because of varying economic cycles, monetary cycles, business cycles and yield curves. Returns also vary by sector within countries and regions. Individual opportunities and risks vary greatly, too. That's a lot of variation compared with a local mandate.
The benefits of global investing can be seen not only in enhanced diversification and risk mitigation, which reduce overall volatility and smooth out spikes in volatility, but also in the sheer profusion of sources for adding value. After all, there are more than 16,000 issues in the Barclays Global Aggregate Index - which is an enormous pool for an active manager to fish in.
So, when a manager isn't really investing globally, there's a lot being left on the table. The risks of overconcentration among the usual suspects - the US, for example, or Europe - include becoming nearsighted; when opportunities arise, they often arise swiftly and in unexpected places. Can your manager take advantage of them?
To Hedge or Not to Hedge
Global bond portfolios fall into one of three camps when it comes to hedging out currency risk: unhedged, hedged or partially hedged (cross-hedging strategies fall into this gray area). This isn't about right or wrong. It's about your desired volatility target as an investor.
For core bond mandates, the answer is clear: hedge the currency exposure. Unhedged and partially hedged global bond portfolios have a significantly higher risk profile than hedged global portfolios, and even higher than some high-income portfolios.
That's because currency is nearly twice as risky as fixed income.
In contrast, over the last two decades, currency-hedged global bonds have consistently been far less volatile than unhedged global bonds, and even less volatile than home country bonds, thanks to the benefits of economic diversification.
While it may be appropriate to take on currency risk opportunistically in some global bond portfolios, core bond investors - those who are seeking to use bonds as an offset to the volatility of risk-seeking assets in their asset allocation - should adopt a hedged portfolio as their default position.
Too Much of a Good Thing
High-yield and emerging market debt have their place in a global bond portfolio. But for investors seeking the safety and stability of a core bond mandate, high-yield and emerging market investments should be limited.
That's because, in significant quantities, the volatility of high-income sectors - bank loans, high-yield debt, emerging market sovereign and emerging market corporate debt - shifts the overall volatility of a portfolio from moderate to high.
How much is too much? Portfolios that exceed a limit of 25% in debt rated below investment grade will likely find themselves exceeding the risk tolerance of the core bond investor. Currency-hedged portfolios that stick to opportunistic investment in high-yield and emerging market debt should remain within the core bond volatility zone.
To One Thing Constant Never
Similarly, the average duration, or interest rate sensitivity of the portfolio, should never stray far from an intermediate-duration target. Why? Once again, the answer comes down to overall portfolio volatility.
We find that in order to be consistent with the risk profile of a core bond mandate, the duration target of a global bond portfolio should be neither short nor long. The midpoint of the global bond market, as measured by the Barclays Global Aggregate, has historically run between 4.5 years and 7.5 years, depending on interest rate levels. Like most home country core mandates, this widely used benchmark has an intermediate duration.
Maintaining a reasonable range around that target allows managers to control volatility. Some managers do not maintain such a range. They roam very short and long, depending on their expectations for interest rates globally. Variable duration is in itself a source of volatility, particularly at the long end.
Remember that the risk profile of a core bond mandate is intended as a strategic offset to the volatility of risk assets.
Delivering on the Global Core Solution
Global bond managers that focus strategically in a single region or high-income sector leave their currency positions unhedged, or widely vary their overall portfolio duration - even if they excel at any of these decisions - driving portfolio volatility out of the core bond investor's comfort zone.
What makes a global bond portfolio a core bond solution? It's not that complicated: a truly global and diversified composition. Hedged currency exposures. Opportunistic allocations to high-income sectors. And a reasonable range around an intermediate duration. There's no need to reach for the stars - and increase risk-taking - when designing a global core portfolio. History has already shown that this solution delivers.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.