By Jenna Barnard, CFA
Foreign bonds can offer diversification benefits, but many non-U.S. developed markets offer subpar yields. Jenna Barnard, Co-Head of Strategic Fixed Income, argues how this seeming disadvantage can be turned into a benefit for U.S. dollar-based bond strategies that practice currency hedging.
We believe the divergence in interest rate policy across the developed world since 2014 has been a prime opportunity for global bond managers to differentiate themselves and pick the "best" countries in which to gain duration exposure.1 Over this five-year period, central banks in Europe, Japan and Australia have only cut interest rates. The UK and Sweden have cut and then modestly hiked rates. In contrast, the U.S. and Canada have raised rates multiple times in what has constituted a full cycle of interest rate hikes. The reasons for this divergence are well known: stubbornly low growth and inflation in much of the developed world that has proven impossible to escape.
Main Policy Interest Rates
Source: Bloomberg, as of 12/31/13 - 4/30/19
From 2018 onward, the outright difference between the U.S. benchmark interest rate (now at 2.5%2) and rates in the rest of the world became impossible for managers of U.S. dollar-based (USD) bond strategies to ignore for a different reason: foreign currency hedging.
Interest Rate Parity
Covered interest parity (CIP) is the closest thing to a physical law in international finance. It holds that the interest rate differential between two currencies in the cash money markets should equal the differential between the forward and spot exchange rates."
-Bank for International Settlements (BIS)
The hedging cost/benefit is the difference between interest rates in the home country (in this case, the U.S.) and the foreign market. Where interest rates are lower than in the U.S., currency hedging results in additional return equivalent to the interest rate difference. Where interest rates are higher in other countries, the difference is paid away when hedging currency.
If done properly, investors in USD-based strategies receive "yield" that is in addition to a bond's normal payout, boosting overall returns. This boost will persist for as long as U.S. interest rates remain higher than the rest of the developed world. In contrast, when managers invest in emerging market bonds, where interest rates are higher than in the U.S., currency hedging can negate the entire extra yield derived from buying these countries' bonds.
10-Year Yields When Hedged Back to USD
*Assumes hedging with three-month forward contracts, net of expenses. Source: Bloomberg and Janus Henderson, as of 4/30/19.
The pain inflicted on foreign bond funds from low interest rates can, in contrast, be beneficial for USD-based strategies. By buying a low-yielding 10-year bond in those countries with a depressingly favorable backdrop (low inflation, low growth) and hedging the currency back to USD, managers can potentially reduce currency risk, provide diversification and generate an excess annual "yield" on the bond.
The backdrop for bond investing in much of the developed world remains stubbornly slow-moving. Too-low inflation and, in some cases, weak economic growth remain the depressing hallmarks of many economies. Sourcing duration from these government bond markets has proved predictably successful. Even in the "reflationary" global market environment of 2016 to 2018, yields in many of these sovereign bond markets only moved modestly higher, in sympathy with U.S. yields but nowhere near the extent of U.S. yields. Once this environment faded, yields collapsed back down to or close to the lows of the summer of 2016. In our opinion, investment managers can offer USD-based investors the diversification benefits of owning foreign bonds while also minimizing currency risk and potentially picking up a higher return than one could get with equivalent U.S. Treasuries.
1Duration is a measure of bond's price sensitivity to interest rate moves. If a bond's duration is five years, for example, its price will rise by approximately 5% if its yield drops by one percentage point, and vice versa.
2As of 5/8/19
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
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