30 June 2014

How a global bond portfolio can allay interest rate fears

One simple strategy that investors might use is to shorten duration, either by rotating into a fund with a shorter duration profile or adding such a fund to an existing lineup. Although this can prove effective in mitigating the risks of rising interest rates, the primary challenge is that its success depends on rates actually going up.

If rates stabilise or even fall, shortening duration may not be beneficial because of short-term bonds’ lower expected return. Should the fund also employ tilts for or against credit, results again may differ from expectations, depending on credit-spread movements.

In the face of such conditions, investment company Vanguard suggests considering a different approach: global diversification. A global bond portfolio may help investors to:

Maintain strategic exposure to equity and bond market risk premiums;

Receive the diversification benefit of high-quality bonds during periods of higher risk; and

Reduce local interest rate risk.

This strategy also has the benefit of being within the control of investors everywhere.

Global rates have been varied

Vanguard research has shown that global bonds have the potential to effectively diversify an investor’s portfolio of local bonds regardless of where in the world the investor lives. This has been true as long as currency risk is hedged back to the investor’s home currency.

Most of that diversification benefit has come from the diversity of interest rates. As Figure 1 shows, local risk factors—such as inflation, economic shocks, and central bank policy—have generally led to less-than-perfect correlations between interest rates across regional bond markets.

This suggests a benefit of adding global bond exposure: the interest rate movements of many markets can offset one another to some extent, leading to a more stable return.

Global bonds and rising (local) rates

To shed light on today’s environment and the challenges facing investors, Vanguard looked at historical periods when local interest rates were rising. Specifically, our research focused on periods with a negative three-month return in the broad local bond market since 1985.

Figure 2 shows that, in periods of rising local rates, a hedged global bond investment has generally provided a diversification benefit regardless of an investor’s home country.

Of course, both an investor’s local bond market and the global market could have had negative returns—a reminder that diversification does not prevent loss. However, Figure 2 shows that a hedged global investment would have returned more than an investor’s local bond market in most periods of rising rates across many markets since 1985. This is a result of the imperfect correlation of global interest rates shown in Figure 1.

While an investor’s local market may have experienced a rise in interest rates (and therefore negative performance), all rates across the world are unlikely to rise at the same time, or to the same extent.

Also, the global fixed income market may have lost ground in absolute terms, but relative to the investor’s local market, the movement of interest rates around the world mitigated the effect of rising rates. Thus, global diversification can be a powerful tool for investors in any country or region.

Focus on what you can control

Investors who use broad, high-quality bonds for diversification have limited options for reducing the short-term risks of a rise in their domestic interest rates. One possibly underused option is to diversify their fixed income holdings even more broadly.

Over the last three decades, global diversification could have improved outcomes for local bond investors in periods of rising rates. There’s no guarantee that this trend will hold true in the future, but on average, broader global diversification can be a worthwhile strategy. And that strategy—unlike trying to predict interest rate movements—is within every investor’s control.