GUEST BLOG: Is Your Global Bond Fund Riskier than You Thought?

July 16, 2012

This is a guest post from Douglas J. Peebles, Head of Fixed Income at AllianceBernstein. The piece reflects his own opinion and is not endorsed by Reuters. The views expressed  do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Global bond funds continue to attract strong inflows as near-zero interest rates lead many investors to look abroad for assets with attractive yields. As we’ve argued before, global bonds provide many important benefits, but it’s crucial that investors select the right type of fund.

Not all global bond funds are cut from the same cloth. One key consideration that investors often overlook is the extent to which the fund elects to hedge its currency exposure. When a domestic currency depreciates – as it did for US-dollar–based investors during most of the period between 2002 and 2008 – foreign currency exposure can help boost returns from holding global bonds.

This is fine while the good times last. But it’s important to understand that currencies are extremely volatile – much more so than bonds – and adverse movements in currencies can quickly swamp the income and price gains generated from holding global bonds. As such, for investors looking at their global bond allocations as a hedge for their equity risk, choosing not to hedge against currency swings could have disastrous results.

Take 2008, for example.  That year, bonds rallied strongly across the developed world, providing valuable diversification for investors smarting from heavy losses in their equity portfolios…if investors were hedging the currency exposure in their global bond allocations. Those who didn’t got a lot more volatility than they had bargained for, and—depending on their base currency—may have been faced with significant losses in their bond portfolios as well as in their stock portfolios.

That was an extremely volatile year in the currency markets: the yen surged against the US dollar, but the Canadian dollar, Australian dollar and pound all plunged, as shown in the display below. In fact, the gap between the best- and worst-performing currencies in the developed world was a huge 48.8%, six times the difference between the best- and worst-performing bond markets.

As always, to avoid unintended consequences, it’s important for investors to keep their goals in mind. In some parts of the world, investors often use global bond funds as a means to gain foreign currency exposure. That’s okay as long as they understand that such funds can be highly volatile—and more akin to high-yield funds than core funds in nature.

But for the majority of investors who are looking for an anchor for their portfolios and don’t want their bond funds to keep them awake at night, the message is simple: a well-managed global bond fund that hedges its currency exposure is the appropriate choice.

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