Divergent Interest Rates: A Golden Opportunity by Alison Martier, AllianceBernstein

US interest rates look set to rise in 2015, and that’s unsettling for some fixed-income investors. But here’s the good news: US bonds aren’t the only game in town.

Different growth rates, interest-rate cycles and economic policies in other countries mean there are still opportunities to boost returns.

To be sure, overall bond returns in general will probably remain modest. There simply aren’t many pockets of the market that are still cheap. Even so, bonds remain a critical component of any portfolio. They provide investors with a set amount of income and help offset the ups and downs of their equity market exposure.

And as we’ve pointed out before, a globalized portfolio is even more effective at meeting these goals than a domestic-only one because it diversifies interest-rate and economic risk while increasing the opportunity set.

A Year of Economic and Policy Variation

In our view, 2015 may be an especially good year for taking advantage of these opportunities. Although US rates are set to rise, rates in the euro area and Japan are likely to stay low.

The European Central Bank, hoping to jolt the flagging euro-area economy back to life, has already signaled that a full-scale asset purchase program is around the corner. The Bank of Japan, meanwhile, recently doubled down on its own aggressive stimulus campaign after Japan’s fragile economy slipped back into recession. China recently cut interest rates to counter slowing growth.

Economists and investors have even started to waver on the timing of interest-rate hikes in the UK. Earlier this year, many investors—we among them—thought the Bank of England would be the first major central bank out of the gate to tighten monetary policy. Now, rate futures suggest the first hike may not come until 2016.

Broader exposure to these and other non-US markets should help buffer the downside risk US-centric portfolios are likely to experience as rates begin to rise. Indeed, between 1990 and 2013, we found that the Barclays Global Aggregate Bond Index, hedged to US dollars, captured 94% of the average quarterly return posted by the Barclays U.S. Aggregate Index but only 67% of the average quarterly loss.

Put another way: investors who shifted away from the US and toward countries where rates were falling or rising more slowly preserved more of their capital.

“Yes” to Global Bonds, “No” to Currency

Of course, divergent global monetary policies won’t affect interest rates alone. They’ll also have a large influence on currencies. Stronger US growth and the rate-hike expectations that come with it have already boosted the dollar this year, and we think the greenback will extend its gains in the coming months. If it does, investors will want the income from their bond portfolios in dollars, rather than euros, sterling or yen.

So what’s an investor to do when the bond opportunity is outside the US but the currency opportunity is inside the US? The simple answer is to hedge out the currency risk. Doing so is easier—and cheaper—than many investors realize, thanks to currency forwards and futures.

It’s worth the effort. According to our research, exposure to a variety of global currencies increases bond portfolio volatility. In fact, currency-hedged global bonds have been consistently less volatile than both an unhedged global portfolio and a US-only one.

Uncertainty and unease are common when the start of a rate-rising cycle nears. By saying “yes” to global bonds and “no” to currency, investors are more likely to enjoy stability and peace of mind in the year ahead.

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, CFA, is a Senior Portfolio Manager and Director of the Fixed Income Senior Portfolio Manager Team at AllianceBernstein Holding LP (NYSE:AB). 

Divergent Interest Rates: A Golden Opportunity?