By Erin Bigley
Worried about heightened market volatility? It's true that there are some known unknowns ahead: US elections, earnings season, Deutsche Bank (NYSE:DB), a potential interest rate hike. Nonetheless, it's important to maintain interest rate exposure. But we like to take that exposure through the global bond market, not just the US bond market.
Going Global Protects Capital Better
Both markets provide a nice offset to US stocks. In normal environments, both have very low correlation to US equities. But the real power in global bonds comes during extreme downside environments for stocks. When stocks are off more than one standard deviation, hedged global bonds tend to provide an even more negative correlation to stocks than US bonds alone.
What's more, over the last 25 years, the returns of US bond markets were more volatile than the returns of hedged global bond markets, as measured by rolling three-year volatility. Even US bonds' volatility was more volatile than hedged global bonds' volatility.
Yet global bonds provide more than a superior volatility record. They also provide a defense against rising US rates. Over the past quarter century, when US bonds rallied, hedged global bonds rallied nearly as much, capturing 96% of positive quarterly returns. And when US bonds sold off - when US rates rose - hedged global bonds preserved more capital, experiencing only 65% of that downturn.
Going Global Provides Opportunity
But why invest globally when about a third of the global government bond market is trading with negative yields? You should go global now because those negative yields can be turned into an opportunity for US investors, thanks to currency hedging.
Hedging foreign currency back into US dollars accomplishes two things. First, it removes a lot of volatility. When you hedge volatile foreign currency exposure back into dollars, you lower the volatility of the portfolio.
Second, in today's markets, the currency hedge can provide a benefit by increasing the yield.
In the euro area, for example, as of September 30, hedging back into US dollars increased yield by 1.5%. It raised German bunds trading with negative yields up to yields nearing those of US 10-year Treasuries. It lifted the yield on 10-year French bonds trading at 0.2% above the yields on US Treasuries. Even better, it boosted Portuguese 10-year bonds trading at 3.3% to 4.8%.
The key is actively managing these exposures, because hedging relationships change. An actively managed global bond portfolio optimizes the dynamic relationships that comprise the capital markets.
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.