Global Bonds Beg the Currency Question by Alison Martier, AllianceBernstein
With the US dollar poised to rise, there’s never been a better time to reposition into global bonds as your core mandate. But when you do, it’s critical to fully hedge that global portfolio against currency risk.
Here’s why. Bonds typically have two main sources of return: income (the return from coupon payments) and change in price (the return from capital appreciation). Most of a bond’s return comes from income, which is stable. A smaller contribution comes from change in price. This component is comparatively small since, unlike equities, bonds have limited upside; eventually, all bonds mature at par.
Global bonds provide a third source of potential return: currency exposure. Many investors choose not to hedge away the impact of currency fluctuations in the hope that currency exposure will boost returns over the long run. They also assume that multiple sources of return—income, price and currency—will reduce their overall risk. Some simply assume that currency hedging is costly.
It turns out that none of these assumptions is correct.
To begin with, currency hedging can be implemented effectively and cheaply with currency forwards and futures. Furthermore, over long periods, hedged and unhedged portfolios have run virtually neck and neck in terms of historical returns. Between 1994 and 2013, a US dollar-hedged global bond portfolio, represented by the Barclays Global Aggregate, generated 5.7% annualized versus 5.6% for its unhedged counterpart. And that was over a period when the dollar was declining.
But most surprisingly, although currency exposure might have been viewed as a diversifying risk, it did not reduce overall volatility. As shown in the Display, currency-hedged global bonds have been consistently far less volatile than unhedged global bonds, and even less volatile than US bonds—thanks to the benefits of economic-cycle diversification.
This means that currency exposure has contributed nothing to unhedged global bond returns over the past 10 years, while contributing an astonishing three-fifths of overall volatility.
It’s a reminder that currency—in and of itself—is about twice as risky as fixed income. And while it may be appropriate to take on opportunistic currency risk in some global bond portfolios, core bond investors—the investors who are seeking to use bonds as a source of stability in their asset allocation—should adopt a hedged portfolio as their default position.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Alison Martier is Senior Portfolio Manager of Fixed Income at AllianceBernstein Holding LP (NYSE:AB).