KEY TAKEAWAYS

  • With markets pricing in additional rate hikes this year by the major central banks, we believe active duration and yield-curve management will continue to be the key drivers of alpha generation in global bond strategies going forward.
  • Following a material reset in valuations this year, global bonds provide strong diversification benefits to domestic and global equities as well as other fixed-income asset classes.
  • For investors looking to make a global bond allocation, we suggest using a hedged benchmark as a starting point and then allowing currency latitude to capture additional diversification benefits.
  • Given the pitfalls associated with a passive investing approach, we encourage investors to look for an asset manager with an active management philosophy, a global scale, robust research capabilities and a proven track record in successfully managing global bond portfolios.

Valuations across fixed-income strategies have materially reset this year on the back of a sudden and sharp pivot by developed market (DM) central banks aimed at curbing rising inflation pressure. Indeed, heightened rate volatility over the past months has not only impacted risk assets, but also the entirety of the investment-grade-rated global government bond market. In hindsight, this result is not surprising as the global fixed-income market—as proxied by the Bloomberg Global Aggregate Index’s (Global Aggregate)1 risk-return profile—became increasingly vulnerable over time to a spike in interest rates given its longer duration (as both sovereign and corporate issuers refinanced and extended at longer maturities) and lower yield level (as extended bouts of quantitative easing further suppressed global bond yields).

Exhibit 1: Global Government Bonds Have Materially Repriced This Year
Global Government Bonds Have Materially Repriced This Year
Source: Bloomberg. As of 29 Jul 22. Select the image to expand the view.

In our 2017 paper, Global Investing: The Price You Might Pay for Going Passive, we cautioned against the allure and efficacy of passively managed global bond strategies; specifically, their tendency to expose investors to the underlying benchmarks’ declining yield buffer (or compensation) against rising rates. Moreover, we highlighted the inherent inflexibility of the passive approach to this area of the market, including, for example, the inability of a passive manager to replicate a global benchmark, calibrate currency risk, invest in off-benchmark securities or go overweight or underweight sectors based on changes in relative value.

Exhibit 2: The Evolving Risk-Return Profile of the Global Aggregate Index
The Evolving Risk-Return Profile of the Global Aggregate Index
Source: Bloomberg. As of 31 Jul 22. Select the image to expand the view.

We would note that the asymmetric duration risk that comes with global fixed-income benchmarks still persists as the bulk of their duration comprises the US and Japan, where yields of the former are off their lows (but low relative to history) and yields of the latter remain near the zero bound. With markets pricing in additional rate hikes this year by the major central banks—all against the backdrop of slowing global growth, the ongoing Russia-Ukraine conflict, key election cycles across DM and emerging market (EM) countries and simmering Taiwan-related tension between the US and China—we believe active duration and yield-curve management will continue to be the key drivers of alpha generation in global bond strategies going forward.

In our view, the most effective way to accomplish this while mitigating the risk of global rates volatility is to diversify duration in those markets where the interest-rate cycle is stabilizing or poised to ease. This means being thoughtful about which countries to own and where duration is held along the yield curve. Given the substantial variance among the change and movement of absolute yield levels, slopes and shapes of government bond curves, both within and across countries, an active manager such as Western Asset seeks to add value for investors by anticipating and capitalizing on these differences (Exhibit 3). For a summary of the key drivers behind our global outlook and a description of where we currently see value across global fixed-income markets, please refer to our Global Outlook.

Exhibit 3: Western Asset’s Active Approach
Western Asset’s Active Approach
Source: Bloomberg, Western Asset. As of 30 Jun 22. Select the image to expand the view.

The potential diversification power of global bonds can be seen in the varying degrees of correlations across a select number of government bonds (Exhibit 4), all of which are a function of the differences in economic cycles, fiscal policies and central bank policies across countries.2 These findings should encourage investors to reevaluate continually the potential for home-country bias when considering their fixed-income allocations.

Exhibit 4: Yield Correlations Across Global Bond Markets Continue to Ebb and Flow
Yield Correlations Across Global Bond Markets Continue to Ebb and Flow
Source: Bloomberg. As of 31 Jul 22. Select the image to expand the view.

For investors with broad asset allocations, “going global” in fixed-income has historically provided the strongest portfolio offset when growth assets (e.g., equities) have disappointed. As Exhibit 5 highlights, global bonds can provide strong diversification benefits to domestic and global equities as well as other fixed-income asset classes.

Exhibit 5: Global Bonds Have Offered Strong Diversification Benefits
Global Bonds Have Offered Strong Diversification Benefits
Source: Bloomberg. As of 31 Jul 22. Select the image to expand the view.

A major source of appeal for global bonds, in addition to coupon income and capital appreciation, is the incremental return that can be obtained from currency exposure. However, unlike income, which is a fixed component of a bond’s total return, currency moves are unpredictable with the potential of negatively impacting the value of income payments and amplifying bond price volatility. We are always mindful of the risk/reward tradeoff of investing in global bonds on an unhedged basis, where one assumes currency risk, or on a hedged basis, where one avoids currency risk.

Exhibit 6: What Is the Better Choice – Unhedged or Hedged? Comparative Annual Returns
What Is the Better Choice – Unhedged or Hedged? Comparative Annual Returns
Source: Bloomberg. As of 31 Jul 22

A comparison of annual returns over the last 15 years between the unhedged and hedged versions of the Global Aggregate Index suggests that the latter may be the best option (Exhibit 6). The volatility of the unhedged series also has been consistently higher than the hedged series when looking back over a longer time frame. As a result, the risk-adjusted return of the hedged series (as measured by the Sharpe ratio3) is much more attractive (Exhibit 7).

Exhibit 7: Hedged Bonds Produce Better Risk-Adjusted Returns Over Time (3-Year Rolling Sharpe Ratio)
Hedged Bonds Produce Better Risk-Adjusted Returns Over Time (3-Year Rolling Sharpe Ratio)
Source: Bloomberg. As of 31 Jul 22. Select the image to expand the view.

This finding underscores two important points:

  • The outlook for major global currencies plays a key role in the choice of a hedged or unhedged global bond benchmark. For example, the US dollar rallied significantly during 1995-2001, experienced a period of sustained weakness during 2002-2013 and is now back at a multi-year high. The choice of the wrong benchmark, particularly at the start of a key inflection point, could result in a significant difference in portfolio return.
  • The benefit of hedging away currency risk does outweigh its cost (which is low given the breadth and depth of the forward currency market).

For investors looking to make a global bond allocation, we suggest using a hedged benchmark as a starting point and then allowing some currency latitude (i.e., the ability to go both long and short select currencies). A more active approach to currencies may moderately increase portfolio volatility, but will—over a market cycle—lower the correlation (and therefore improve diversification benefits) of the portfolio with other asset classes.4

To summarize, we believe actively managed global bond strategies have an inherent advantage over passive strategies in five key areas:

  1. The latitude to invest across the full spectrum of global interest rates and credit markets, including those that are off-benchmark
  2. The ability to rotate across sectors (i.e., overweight sectors that offer value or underweight sectors that are expected to lag)
  3. The flexibility to tactically manage duration and yield-curve positioning to mitigate interest-rate sensitivity
  4. The ability to manage (and seek to exploit) currency volatility over different market cycles
  5. The flexibility to enhance diversification and complementary strategies within a portfolio
Given the complexity of global bonds and the pitfalls associated with taking a passive approach toward this market, we encourage investors to look for an asset manager with: a) an active management philosophy, b) a global scale and robust research capabilities and c) a proven track record in successfully managing global portfolios (Exhibit 8). For more information, please refer to our May 2022 paper, Going Global: The Western Asset Approach to Global Bond Investing.

Exhibit 8: Global Aggregate (USD Hedged) Representative Account Performance Since Inception
Global Aggregate (USD Hedged) Representative Account Performance Since Inception
Source: Bloomberg, Western Asset. As of 31 Jul 22. Select the image to expand the view. Past investment results are not indicative of future investment results. Please refer to the Performance and Risk Disclosure for more information.
ENDNOTES
  1. The Bloomberg Global Aggregate Index is a multi-currency benchmark that comprises global investment-grade debt.
  2. Note that correlations are not necessarily stable and might change over time; manager judgment might be necessary
  3. The Sharpe ratio is a measure that indicates the average return minus the risk-free rate divided by the standard deviation of return on an investment. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.
  4. Interestingly, when passive managers tie a strategy to an unhedged or hedged benchmark, they are essentially making an “active” decision.