One big misunderstanding of risk in many clients’ portfolios comes from the area where one least expects it — fixed income.
The misconceptions around duration, yield and liquidity can lead to unintended consequences for investors. Diversifying a client's risk in fixed income may lead to a better, more stable performance, while decreasing susceptibility to any single dominant risk. Thinking globally is one way to diversify a portfolio.
While not a new concept, global bond funds have been gaining in popularity due to their increased diversification, larger opportunity set and ability to reduce exposure to any single central bank. In this article, we will look at understanding where the elements of risk in a fixed income portfolio can come from and how one may be able to reduce them through a globally diversified fixed income portfolio.
The misconceptions around duration, yield and liquidity can lead to unintended consequences for investors.
EXAMINING DURATION
The element of risk that can be a major driver in the volatility and return in a fixed income portfolio is duration. However, how should one think about duration in their fixed income portfolio? The tendency, typically, is to think of the risk in the portfolio from duration relative to U.S. interest rate moves. Now that the Fed has indicated its path to normalizing rates, duration solely in the U.S. will be vulnerable to any unexpected policy changes.
However, when one considers duration as the interest rate exposure to a specific market, diversification across multiple regions offers the opportunity to rotate the duration into those markets that are less correlated.
Looking at the correlations between rates over the past 10 years, developed market economies have had relatively high correlations with U.S. rates. However, over the past 5 years, as markets and central bank policies have diverged, this correlation has come down dramatically. This divergence has offered many total return opportunities outside the U.S. By looking solely at a single duration number, one cannot get the full picture of the potential risk and opportunity in a portfolio.
As the world’s largest bond market, the U.S. represents approximately 40% of global fixed income.
As the world’s largest bond market, the U.S. represents approximately 40% of global fixed income. Investing in vehicles that resemble a U.S.-centric Intermediate Bond index exposes the investor to a less-diversified risk profile. These portfolios are very exposed to movements by the Federal Reserve with approximately 70% of their exposure in Treasurys, agencies and mortgage-backed securities. In a global portfolio, direct exposure to any single central bank can be substantially reduced.
As interest rates decreased, the demand for income led investors toward securities with greater yield, and subsequently, greater volatility. Using corporate ratings as a guide, the annualized volatility in higher yielding securities has increased while total return has fallen, resulting in lower Sharpe ratios.
TIME FOR HEDGING
Advisers may want to consider that away from duration and yield, the importance of hedging currencies in a global fixed income portfolio cannot be overlooked. Typically, a fixed income portfolio is part of an asset allocation strategy to reduce volatility and provide a stable risk-return profile. A currency hedged portfolio historically has generated a lower-volatility return, with a low correlation to equities, complementing a well-diversified portfolio and providing the stability potential an adviser seeks.
Finally, as investment banks around the world reduce their bond inventories, liquidity has been reduced in fixed income. In this new environment, smaller, more nimble portfolios are able to maneuver between markets and securities, allowing for more diversity and the ability to utilize a larger opportunity set.
When considering the potential benefits of global bond investing, it’s important to keep in mind that foreign securities can be influenced by political, social and economic factors. Special risks include exposure to currency fluctuations, less liquidity, less developed or less efficient trading markets, lack of comprehensive company information, political and economic instability and differing auditing and legal standards. In addition, investments denominated in foreign currencies are subject to the risk that such currencies will decline in value relative to the U.S. dollar.
To sum up, the spectrum of the global bond asset class is wide. Portfolios range from those that are high quality, have lower volatility and correlations to equities, which are predominantly hedged to the U.S. dollar to those that are completely unhedged and have higher volatility and higher equity correlations.
Advisers may want to point out to their clients that the key to security selection is really determining what the client is looking for from their fixed income portfolio.
