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.
More and more, global bonds are being used as core portfolios for investors seeking an anchor to windward for their stock investments. While this is generally a good thing, some investors are discovering that the decision to go global can have unintended consequences: certain global bond portfolios have much higher volatility than is usually associated with core portfolios.
Bonds generally have two main sources of return: income (the return from coupon payments) and price (return from capital appreciation). Most of a bond’s return usually comes from income, which is a very stable source of returns. A smaller contribution comes from prices changes. This component is smaller, since, unlike equities, bonds have limited upside; they mature at par.
Global bonds add an additional source of potential returns: currency exposure. Currency hedging—which can be implemented simply and cheaply with currency forwards or futures—eliminates the impact of currency changes on bond returns. Nonetheless, many investors choose not to hedge, in the hope that currency exposure can boost returns. They also assume that multiple sources of return will reduce their overall risk. It turns out, though, that neither of these assumptions is correct.
Between 1996 and 2011, a US dollar-hedged global bond portfolio, represented by the Barclays Capital Global Aggregate Bond Index, would have generated nearly identical returns to an unhedged portfolio— 5.9% versus 5.8% annualized. This may come as a surprise to many investors, given the decline we’ve seen in the US dollar.