A portfolio stabilizer: Global (hedged) bonds

November 12, 2018

 

One reason many clients hire an advisor is to help them weather market downturns. This is especially true for risk-averse clients.

While there are various ways advisors can attempt to position portfolios to handle rough waters, Vanguard research1 shows that a global bond allocation can provide additional diversification, reducing a portfolio's risk without necessarily decreasing its expected return. We found that the benefits of diversification resulted when bonds from all markets and issuers were included, provided, however, they were hedged against currency fluctuations.

In the graphic below, we illustrate that when global bonds are hedged, they can offer lower volatility than bonds held in the currency of the investor's home country, even those of the large and diversified U.S. bond market.

Hedged global bonds tend to have lower volatility than local-market bonds

Hedged global bonds tend to have lower volatility than local-market bonds

Sources: Vanguard calculations, based on data from Bloomberg Barclays and Thomson Reuters Datastream.

Notes: Data cover the period from January 1, 1988, to June 30, 2017. For the United States, the United Kingdom, and Australia, global bonds are represented by the Citigroup WGBI from January 1, 1988, to December 31, 1989, and the Bloomberg Barclays Global Aggregate Bond Index thereafter. For Canada and the euro area, global bonds are represented by the Citigroup WGBI from January 1, 1988, to January 31, 1999, and the Bloomberg Barclays Global Aggregate Bond Index thereafter.

"Many of the economic differences between countries are captured by the foreign exchange market, which can cause significant volatility in the short run," said Todd Schlanger, a senior investment strategist in Vanguard Investment Strategy Group.

Currencies factor in differences in interest rates. So even when global bonds offer different yields, investors may earn roughly the same total return as bonds in their own currency, Schlanger said. Specifically, hedging the currency differential effectively provides roughly the difference in expected returns as bonds in the investor's home country.

Therefore, when adding global securities to a client's bond portfolio, especially to portfolios with larger allocations to fixed income, currency-hedged global bonds can help diversify the portfolio and lower volatility, as shown in the graphic below, without necessarily giving up return.

Volatility reduction benefits resulting from a more global hedged fixed income allocation

Volatility reduction benefits resulting from a more global hedged fixed income allocation

Sources: Vanguard calculations, based on data from Bloomberg Barclays, Citigroup, and MSCI.

Notes: For the United States: Data cover January 1, 1988, to June 30, 2017. Global stocks are represented by the MSCI World ex USA Index. Global bonds are represented by the Citigroup WGBI ex-USD (USD hedged) to December 31, 1998, and the Bloomberg Barclays Global Aggregate ex-USD Float Adjusted Index (USD hedged) thereafter. U.S. bond returns are represented by the Bloomberg Barclays U.S. Aggregate Bond Index.

"Unhedged global bonds can experience significant volatility, even as the long-run expected return from currency is close to zero," Schlanger said. "Currency-hedged global bonds, however, tend to have lower volatility than the U.S. bond market, which makes them well suited for the core of a bond portfolio where an investor is looking for ballast. They can also provide much needed counterbalancing when equities are falling."

This is illustrated in the graphic below, which shows that during the worst 10% of monthly U.S. stock returns over the past 30 years, hedged global ex-U.S. bonds provided among the best counterbalancing relative to other bond segments.

"It is a widely accepted principle that diversification is the only free lunch in investing," Schlanger said. "Many investors understand that principle when it comes to global equities, but it also applies to diversification with global bonds, provided you hedge the currency."

High-quality bonds are the best diversifier to equity risk

Median return of various asset classes during the worst decile of monthly U.S. equity returns, 1988–2017

High-quality bonds are the best diversifier to equity risk

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Source: Vanguard, based on data from Thomson Reuters Datastream, Bloomberg, HFRI, MSCI, FTSE, CRSP, S&P, and S&P Dow Jones Indices.

Notes: U.S. stocks are represented by the Dow Jones Wilshire Index through April 2005, the MSCI US Broad Market Index through June 2013, and the CRSP US Total Market Index thereafter. Emerging markets stocks are represented by the MSCI Emerging Markets Index, real estate investment trusts (REITs) by the FTSE NAREIT Equity REITs Index, dividend stocks by the Dow Jones U.S. Select Dividend Index, commodities by the S&P GSCI Commodity Index, high-yield bonds by the Bloomberg Barclays U.S. Corporate High Yield Bond Index, emerging markets bonds by the Bloomberg Barclays EM USD Aggregate Index, investment-grade corporate bonds by the Bloomberg Barclays U.S. Corporate Index, U.S. Treasury bonds by the Bloomberg Barclays U.S. Treasury Bond Index, municipal bonds by the Bloomberg Barclays U.S. Municipal Index, hedge funds by the HFRI Fund Weighted Total Return Index, and international bonds by the Bloomberg Barclays Global Aggregate ex USD Bond Index. The Dow Jones U.S. Select Dividend Index started in January 1992, the Bloomberg Barclays EM USD Aggregate Index started in January 1993, hedge fund data started in 1994, and the Bloomberg Barclays Global Aggregate ex USD Bond Index started in January 1990. All data are through December 31, 2017.

Vanguard Total World Bond ETF

To help clients invest in currency-hedged global fixed income, Vanguard launched Vanguard Total World Bond ETF (BNDW) in September 2018.

The Total World Bond ETF is an ETF of ETFs. As of June 30, 2018, it was made up of 45% Vanguard Total Bond Market ETF (BND), which invests in investment-grade2 U.S. bonds, and 55% Vanguard Total International Bond ETF (BNDX), which invests in non-U.S. investment-grade sovereign and corporate bonds. As such, Total World Bond ETF offers a portfolio of more than 13,000 bonds (as of August 31, 2018). The new ETF has an estimated expense ratio of 0.09%. It seeks to track the Bloomberg Barclays Global Aggregate Float Adjusted Composite Index.

Rich Powers, head of ETF Product Management, said the Total World Bond ETF offers convenience for advisors and clients. It is the first ETF to offer exposure to a market capitalization version of the global investment-grade bond market, he said.

"Total World Bond can serve as a one-stop shop for the entire fixed income portion of a client's portfolio," Powers said. "It can also serve as the core fixed income holding, which you can supplement with other funds depending on your market view or on a client’s risk tolerance and time horizon."

1 Todd Schlanger, David J. Walker, and Daren R. Roberts, 2018. Going global with bonds: The benefits of a more global fixed income allocation. Valley Forge, Pa.: The Vanguard Group.

2 A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.

Download the complete Fall 2018 issue of ETF Perspectives

Notes:

  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • All investing is subject to risk, including possible loss of principal.
  • Vanguard Total World Bond ETF is subject to currency hedging risk, which is the chance that currency hedging transactions may not perfectly offset the fund's foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in relevant currency exchange rates. The Fund will incur expenses to hedge its currency exposures.
  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

 

Our insights straight
to your inbox

Our insights straight to your inbox

Receive our latest Advisor's Digest
research
and commentary sent the
first business
morning every week.

A weekly digest of our latest research and commentary. Topics include the economy and markets, portfolio strategy, ETFs, and practice management.


Fund openings/closings, fund manager changes, dividend distributions, webinars, and other events you might want to know about.



Already registered? Log on to
manage your
email subscriptions.

Advisor's Digest

for September 16, 2019

Advisor's Digest for September 16, 2019

Advisor's Digest

for September 16, 2019