We've made the case that it's generally a good time for fixed income given bonds' revaluation to yields well above the secular stagnation levels that existed prior to the 2022 bear market. These higher yields, combined with the shift by most developed market central banks from rate hikes to cuts, suggest that this sleeper bull market is set to continue. But how does global fixed income fit within this context?
This post makes the case for hedged global fixed income in nine figures.
Spoiler Alert:
While the returns from hedged global bonds are not always higher than domestic bonds, they are typically less volatile. Additionally, the global bond market offers an expanded opportunity set for adding value through active management. If history is any guide, this combination of lower volatility and greater alpha potential positions active, global hedged portfolios to achieve compelling risk-adjusted returns going forward.
First, let's look at the starting point of the average investor: how big are international allocations to stocks and bonds vs. domestic allocations? Depending on the country, international equity exposure ranges from 15-80%, with most allocating 50% or more to international equities. By contrast, allocations to international fixed income range from 5-50%, with most allocating well under 20% to international/global bonds.
Global and international bond allocations are less common than allocations to international equities (share, %).
Source: Thinking Ahead Institute/Willis Towers Watson (reproduced with permission); Morningstar
Looking at unhedged global bonds, the lower allocation is understandable: unhedged global bonds are much more volatile than domestic bonds, without necessarily promising much higher returns. The higher volatility of unhedged global bonds is of course the result of their inherent foreign exchange risk, which ends up overwhelming the benefits of the diversification across countries. Absent currency risk, however, hedged global bonds benefit from their diversified exposure to imperfectly correlated bond markets, resulting in less volatility than domestic bonds.
Global unhedged bonds exhibit volatility that can be multiples of the volatility on a domestic bond index. However, hedged global bonds exhibit volatility that is comparable to, or less than, domestic benchmarks, highlighting the importance of currency hedging (annualized standard deviation of total returns, August 2004-July 2024, %).
Source: Bloomberg, PGIM Fixed Income as of July 2024.
* Domestic benchmarks are as follows: AUD: Bloomberg AusBond Composite 0+ Year; CAD: Bloomberg Canadian Aggregate; EUR: Bloomberg European Aggregate; GBP: FTSE UK Domestic Investment-Grade; JPY: Nomura BPI; USD: Bloomberg U.S. Aggregate.
This begs the question: why are global hedged bonds less volatile than domestic bonds? In general, the world's interest-rate markets are highly—but not perfectly—correlated. In the absence of currency risk, this diversification of exposure across dozens of markets results in volatility on hedged global benchmarks that is generally lower relative to domestic bonds.
The imperfect correlation across markets drives the relatively low volatility on hedged global indices (correlation of 10-year government yields across currencies).
Source: Bloomberg, PGIM Fixed Income.
Note: Correlation of monthly yield changes of 10-year government bonds from August 2004 to July 2024. German bunds are used for the euro.
The relative performance of hedged global versus domestic bonds is quite period specific. This is observed in the two panels of Figure 4, which show domestic and hedged global bond market returns over the most recent 10 years (right panel) and the preceding 10 years (left panel). While domestic and global hedged bonds have generally posted comparable levels of return, the relative performance varies across the two timeframes.
Hedged global bonds may not post higher total returns than domestic…(annualized total returns by investor currency, %).
Source: Bloomberg, PGIM Fixed Income
Yet, when looking at the relative risk-adjusted performance, we see that hedged global bonds posted superior risk-adjusted returns over the last 20 years compared with most domestic benchmarks. A quick study of the timeframes below also shows that the risk-adjusted performance was stronger in the first decade from 2004-2014, but less consistently so in the second decade.
…but they generally provide superior risk-adjusted returns relative to domestic indices (total return/volatility by investor currency).
Source: Bloomberg, PGIM Fixed Income
The global bond markets dwarf the size of many popular domestic benchmarks. In addition to providing diversification, this greater range of securities across the government, quasi-government, corporate, and securitized product sectors offer a much wider investment universe. Hence, it also expands the set of opportunities to add value through sector allocation, issuer/issue selection, and duration positioning.
Expanding the opportunity set to global not only offers diversification, but it also broadens the field for adding value through active management (USD trillion).
Source: Bloomberg, Nomura, FTSE Russell as of August 2024.
A global approach provides the opportunity to seek alpha opportunities and diversify credit risk across a range of markets offering comparable spreads in many cases (option-adjusted spread of sectors within each benchmark, bps).
Source: Bloomberg, Nomura, FTSE Russell as of August 2024.
Moving to the application of global hedged to portfolios, Figure 8 highlights the diversification potential of adding the asset class to a domestic bond portfolio by showing combinations varying from 100% hedged global to 100% domestic. Looking at the last 20 years of bond market returns, we can segment the impact of adding global hedged into the three groups observed in the following panel.
Adding a hedged global bond (Global Agg. Hedged) allocation to a domestic benchmark improves overall portfolio risk-adjusted performance, i.e. boosting the efficient frontier (x-axis: standard deviation, annualized, %; lhs: total return, annualized, %; rhs: total return / standard deviation).
Source: PGIM Fixed Income analysis of Bloomberg data.
Granted, in terms of time frame the domestic/international asset allocation is more of a strategic rather than tactical exercise. Nonetheless, since the relative performance of hedged global bonds is rather period specific, it is worth asking the question: how does the timing for adding global hedged look now? First, we look at the standstill carry impact of moving from domestic bonds into global hedged bonds—which is equal to the yield on the global market less the cost of a short-term FX hedge relative to the yield on domestic bonds.
From this perspective (Figure 9), the carry advantage appears average or favorable for Canada, Europe, UK, and the U.S. In other words, for investors in these markets, adding global hedged would increase their carry, or yield, at least initially based the on current yield curve shape. Conversely, investors in Australia and Japan would currently give up carry when buying global bonds—and by a wide margin in the case of Japan.
In addition to the hedged-yield and short-term carry impact of shifting to global, it is equally important to look at the relationship at the back of the curves. Indeed, relative shifts between domestic and global long-term yields will be a significant driver of relative returns.
Japan provides an interesting case where the carry of going international—which is very negative—may be offset by the raw yield differential, which is very positive and more so than usual. This might suggest that while Japanese investors may have lower carry, they may benefit from a narrowing of long-term yield differentials, which would boost the return on global bonds relative to yen-denominated assets (more on this below). Similarly, global yields look a bit higher than average for European investors. In the cases of Australia and Canada, yields on a relative basis are higher than normal, while the yield differential for UK and U.S. investors is less favorable than average with yield reductions below median levels.
How is the timing for a shift to global? (August 2004-August 2024, percentage points. See Appendix for a table representation of the data below.)
Source: Bloomberg, PGIM Fixed Income as of August 2024.
As shown in Figure 8, when looking at the carry impact of going global, Japanese investors by far face the biggest hedged yield give-up of roughly 1.5% on incremental allocations to hedged global bonds. This is a function of the fact that Japan's yield curve is positively sloped—which creates a positive hedged yield— whereas most other DM country yield curves are inverted, rendering their hedged yields negative. To the extent that interest rates do not change, this would prove a substantial performance headwind for hedged global bonds relative to yen bonds.
However, there are three mitigating factors that may yet make a plausible case for hedged global bonds. First, the Bank of Japan is set to continue raising rates in the quarters ahead, while most foreign central banks are likely to cut rates. This should narrow short-term rate differentials and narrow the hedged yield gap between domestic yen fixed income and international bonds by a significant margin.
Second, long-term global yields are higher than average relative to Japan (Figure 9). Should this relationship normalize— i.e., foreign yields fall relative to Japanese yields —hedged global bonds would experience favorable price performance relative to Japan.
Lastly, investors diversifying out of the yen market will vastly broaden their investment universe, which should significantly improve the potential to add value through active management.
In short, while on the face of it, hedged global bonds appear to be a poor option for Japanese investors, the main hurdle—the carry give-up as a result of yield curve slope differences—may be wiped out as short-term rate differentials narrow. Furthermore, the risk of Japanese bonds continuing their bear market stands in a 180-degree contrast to Western markets where rates appear to be biased for stability, or even further declines, likely extending the current bull market. Lastly, global bond returns will benefit from the much broader opportunity set for active management and alpha generation.
While the notion of global fixed income may sound exotic, in fact global hedged fixed income may offer the opportunity to reduce risk and improve risk-adjusted returns while offering a broader opportunity set for adding value via active management.
Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of October 2024.
For Professional Investors only. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. All investments involve risk, including the possible loss of capital.
PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V., located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. PGIM Fixed Income as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Investors seeking information regarding their particular investment needs should contact their own financial professional.
These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.
Any forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fee. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government agency or private guarantor, there is no assurance that the guarantor will meet its obligations. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Diversification does not ensure against loss.
In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR.PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited including those available under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In Switzerland, information is issued by PGIM Limited, London, through its Representative Office in Zurich with registered office: Kappelergasse 14, CH-8001 Zurich, Switzerland. PGIM Limited, London, Representative Office in Zurich is authorised and regulated by the Swiss Financial Market Supervisory Authority FINMA and these materials are issued to persons who are professional or institutional clients within the meaning of Art.4 para 3 and 4 FinSA in Switzerland. In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a regulated entity with the Monetary Authority of Singapore under a Capital Markets Services License to conduct fund management and an exempt financial adviser. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 -Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2024 PFI and its related entities.
2024-7484
Collapse Section