More and more investors are globalizing their bond portfolios these days—with good reason. But when it comes to reducing risk, active management is essential. The French presidential election is just one reason.

Bond investors are going global today because they want more choices at a time when business cycles, monetary policies and yield curves are diverging. That makes sense. Global exposure offers a bigger opportunity set and diversification of interest-rate and credit risk.

Global Bond Money
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Global Bond Money

But there are different ways to get that exposure—and they’re not created equal. For example, a passive strategy that tracks a global bond index actually limits choice.

Why? Because lower-yielding debt is overrepresented in global bond benchmarks. Japan, for example, accounts for a large share of the global bond universe because it issues a large amount of debt. But for maturities out to eight years, Japanese government bonds (JGBs) offer negative yields.

Now consider Australia. It’s only about 1% of the global bond market. But its bonds yield roughly 2% more than JGBs at every point along the curve. For many investors, parking nearly 20% of their money in Japanese debt and 1% in Australian may not offer the best trade-off between risk and return. But that’s the trade-off those who invest passively are forced to make.

Unlike JGBs, Japanese inflation-protected bonds, whose principal value is linked to the inflation rate, do look attractive today. That’s because expansionary fiscal policy at home and improving growth abroad have economists pricing in faster growth and inflation in Japan. But passive investors can’t take advantage of these securities because they’re not in the global benchmark at all.

Want to Limit Downside Risk? Stay Active.

It’s not just potential returns that investors give up when they outsource security selection to the governments or companies that make up an index. They may also be exposing themselves to more downside risk than they realize.

Take France. The outcome of the country’s upcoming presidential election—the second and final round is set for May 7—may have important implications for the stability of the European Union and the future of the euro, and that’s been stoking volatility in European bond markets.

As a result, many investors may want to adjust their exposure to French debt, which accounts for about 6% of the global bond market, until the outcome of the election is known. But passive investors don’t have that option.

To get the full benefit of a global allocation, we think investors should embrace a hands-on approach that gives them more flexibility rather than tether their portfolios to a benchmark. This way, they can adjust exposures to take advantage of opportunities as they arise while limiting risk and potential drawdowns.

For instance, when the UK surprised markets last year by pulling out of the European Union, investors withdrew money from stocks and other risky assets and poured it into UK government bonds, which make up about 4% of the global bond market.

Astute investors might have reaped some of the rewards by quickly increasing their UK exposure—and in this case, hedging their exposure to the pound. Passive investors would have been locked into that 4% weighting.

Investors increasingly recognize that going global can help to maximize opportunities while reducing volatility and risk. But investing in an index—even a global one—doesn’t do either.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by Erin Bigley, Alliance Bernstein