Three 'tips' for investing in bonds

Three 'tips' for investing in bonds

Current yields are at historical lows: in the mid-1990s you could easily be paid more than 8% for lending to the UK government with a 10-year maturity. The fixed income landscape has changed completely over the last 20 years, first by central banks' commitment to inflation targeting, and then by post-financial crisis "extraordinary" monetary policies. The net result has been, from a yield perspective, to make government bonds far less attractive than they used to be.
But if we look at current government bonds around the world, UK nominal yields are not particularly low. For instance, 10-year United States government bonds currently pay around 2.2%, whereas German bonds are at about 0.4%, Greek around 5.4%, French at about 0.7%, and Brazilian at around 10.1%. What we see is that government bond yields around the globe are widely scattered.

How should investors respond?

Should investors be sceptical about investing globally with the fear of compromising returns by moving away from a high-yield (home) country to lower-yield countries like Japan or Switzerland? Should investors in low-yielding markets rush overseas?
Before making this decision, there are three ‘tips' investors should be aware of.

Tip 1: No such a thing as free lunch

Government bond markets tend to be liquid, globally traded and intensely researched. There are very limited arbitrage opportunities, or none at all. Securities are fairly priced and investors cannot make gains without bearing risk.
This means that if fixed income returns are hedged for currency risk, the gain/loss made on the FX forward contract offsets the lower/higher yield on the foreign bond. Let's take a simplified example.
We'll assume that the yield on a one-year UK bond is 2% and on the equivalent US bond it is 4%, and that the GBP/USD spot rate is 1:1. In one year, the investor receives either £1,020 or $1,040. In an efficient market, this difference would be offset completely in the forward GBP/USD rate, which would settle at 1:1.0196. The UK investor purchasing the US bond would receive $1,040/1.0196 = £1,020, the same as if they had purchased the UK bond.
If that were not the case and there was perfect capital mobility of domestic and foreign assets, investors could borrow funds in the UK, invest them in the US and make a risk-free profit – enjoying a "free lunch".

Tip 2: Emerging markets. All that glitters ...

This "no arbitrage" condition is technically known as the Covered Interest Rate Parity, or CIRP, which generally holds over long time periods. It would be nice if it worked in all circumstances, such as between the UK and Brazil, where there are significant differences in yield. But here is the second tip: in practice it only holds for bonds with very similar risk characteristics, such as the UK and the US.¹ This is because UK and Brazil have different country risk profiles and Brazilian bonds pay a premium to investors for bearing additional credit and default risk.

Figure 1: Annualised returns of domestic and global government bonds from the perspective of investors in the stated country

January 1985–July 2017

Source: Thomson Reuters Datastream. "Domestic bonds" refers to each country's respective component of the Citigroup World Government Bond Index – All Maturities, with returns measured in that country's currency. For Australia, Canada, France, UK and Switzerland, "global bonds – local currencies" is defined as the Citigroup World Government Bond Index – All Maturities, measured in local currencies terms. For Japan and the United States, "global bonds- local currencies" is defined as the Citigroup World Government Bond Index Ex-JPY – All Maturities and Citigroup World Government Bond Index Ex-USD – All Maturities, respectively. "Global bonds – hedged" refers to the same indices used for "global bonds – local currencies" with returns hedged back to each country's home currency. "Return contribution of hedging currency" is the difference between "global bonds – hedged" and "global bonds – local currencies".

If we focus only on developed countries, the CIRP implies that, once global bonds are hedged back to the home currency, their yield should match the yield provided by a local bond denominated in its local currency. We can see it at work in Figure 1. The red dots represent the return on global bonds hedged for each country's domestic currency. This is the sum of the gain/loss on the currency hedging contract (blue bars) and the return on a portfolio of global bonds expressed in their local currencies' terms (turquoise bars). The green bars represent the return of each country's domestic bonds. As the CIRP would suggest, the hedged return on global bonds tends to be very close to the return of each country's domestic bonds, but quite different from the global bonds portfolio expressed in local currencies' terms.

Tip 3: The risk reduction game

At this point, some investors might raise the question: "If domestic yields and exchange-hedged international yields end up being very similar over the long term, why bother investing in global bonds?" And here is the third tip: investing globally and hedging for currency movements can significantly reduce risk. In today's markets, capital allocation is almost frictionless, but interest rates globally don't rise or fall at the same time. This allows investors the potential to instill more stability in their portfolios by holding global bonds.
Using the same data as in Figure 1, Figure 2 shows the volatility of three government bond portfolios: global bonds without currency hedging, global bonds hedged to sterling and UK government bonds. The 3-year rolling volatility of the portfolio of global government bonds hedged for currency movements has consistently been lower than the volatility of the unhedged global portfolio.

Figure 2: 36-month rolling volatility of global government bonds returns for a UK investor

Source: Thomson Reuters Datastream. Returns volatility is computed as the annualised standard deviation of monthly returns. "Global bonds – unhedged" refers to the Citigroup World Government Bond Index - All Maturities, unhedged, in GBP; "global bonds – hedged" refers to the Citigroup World Government Bond Index - All Maturities, hedged to GBP and "UK bonds" refers to the UK Citigroup World Government Bond Index - All Maturities.

This is because in an unhedged portfolio, currency volatility is added on top of the bond markets' fluctuations. But what is really interesting is that, due to the benefits of diversifying yield, the hedged global portfolio has had consistently lower volatility than the UK bonds portfolio.
Investing in global bonds may not offer a "free lunch", but over the long term and with currency hedging investors can reduce the volatility of their investment without compromising on yields. Just because it isn't "free" doesn't mean it isn't good!

1 Transaction costs and counterparty risk on FX contracts can also lead to the CIRP not to hold. In addition, recent research has highlighted how the post-Global Financial Crisis regulatory environment can create arbitrage opportunities that deviate from the CIRP. For further details on this topic refer to Du et al. (2017).

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