Thu, 13 Oct 2011
Buying unhedged foreign bonds introduces additional risk and volatility in the part of your portfolio meant to provide a ballast against risk, says Vanguard's Chris Philips.
Christine Benz: Hi. I'm Christine Benz for Morningstar.com. I recently interviewed Christopher Philips, who is a senior investment analyst with Vanguard's Investment Strategy Group. One of the topics we discussed was the role of foreign bonds in investor portfolios.
Chris, thank you so much for being here.
Christopher Philips: My pleasure.
Benz: So, you and your team have recently looked at global fixed income. It's been a very hot category. Investors have been wanting to globalize their bond portfolios. You looked at, first, the two different flavors of foreign bond funds, the hedged portfolios and the un-hedged portfolios. Let's discuss those two types and the risk/reward characteristics that come along with each?
Philips: Sure. So, when you broadly think of global fixed income, most investors would merely think of it in the same terms they think of global equities, where they are exposed to currency fluctuations that, if the dollar goes up, my investments will go down and vice versa.
What we do know is that a lot of managers out there, and there are some funds out there and ETFs, that may actually remove that currency exposure from the portfolio, thereby preserving the underlying characteristics of bonds. Why that's important with fixed income is that, if you think about the role of bonds in the portfolio, it's to diversify your equity risk, or your other high-risk assets in the portfolio.
Benz: Provide ballasts for that portfolio...
Philips: Exactly. Now, if currency is a volatile asset class in itself, and you layer that on top of a non-volatile asset, such as bonds, then you can actually end up with something that doesn't act like you would expect it to act--which is why, very broadly, investment management firms and academics have largely segmented global fixed income into this idea of un-hedged or currency exposed bonds, and then those where currency exposure has been removed.
Benz: Okay. So, your view, when you look at optimal allocations, would you say that investors are better off opting for the hedged or the un-hedged portfolio.
Philips: This really gets down to a philosophical discussion about whether an investor believes they can predict currency markets or whether they are interested in volatility and true portfolio diversification. So, if someone does have the opinion that they can actually predict currency movements…
Benz: ... First, what do you think about the typical investor's chances of predicting currency movements?
Philips: We're not optimistic. So, what we've found is that, like trying to pick one stock versus another or trying to pick the bottom or top of an equity market, trying to time the currency markets, when the dollar is going to start declining or start appreciating, is very difficult and very often not executed efficiently.
So, if that's the case, then we believe that for that volatility reduction, investors should actually focus on those products and portfolios that have all that currency exposure removed from that portfolio.
Benz: So the hedged foreign bond funds.
Benz: So, assuming I've decided to look at adding a hedged foreign bond to my portfolio, what is the sort of allocation I would think about as a percentage of my total fixed-income weighting?
Philips: It's an interesting dynamic, because foreign bonds are almost exclusively government bonds; government bonds make up around 85% to 88% of the global bond market outside of the U.S., so you get very little corporate exposure. So, you have this diversification benefit from all the foreign countries out there, but you give up some of the credit spread that you get in U.S. bonds. So, that's an important dynamic to account for.
So, in thinking about all this, we've come to the conclusion that again, kind of like the equity recommendations, that 20% to 40% band [of the fixed income portion of a portfolio] seems to make the most sense for investors, and actually this gets to, where, if you have a more bond-centric portfolio, so say, 60% in bonds and 40% in stocks, then you can actually have a little bit more in global hedged fixed income than someone who might have only 20% in bonds, because there equity risk is dominating your portfolio anyway.
Benz: How about emerging-markets bonds. I know a lot of investors want to go out and get a dedicated exposure to EM bonds. What's your take on that strategy?
Philips: EM bonds make up around 10% to 12% of the global bond market, so we think they can make a lot of sense in the portfolio, as long as they are used with the right intentions and the right process.
So, a diversified EM bond exposure would be the most useful. What investors do want to be aware of: there are three flavors of EM bonds out there. There are dollar-denominated, so-called Brady bonds... it could be Brazil actually issuing a bond in the U.S.
Then there are local currency denominated bonds, where Brazil may actually issue its own bonds denominated in the real.
And then you actually have the potential for hedged bonds. So, a Brazilian-denominated, but with that currency exposure hedged.
They all can actually perform quite differently, and so by investing in one versus the other you just need to be aware of what you're getting and what the potential impacts might be.
Benz: Obviously, if you have the currency volatility in the mix, that's higher volatility for the portfolio overall.
Philips: Exactly. And in emerging-market bonds, it can be significant volatility.
Benz: Right, right. Well, Chris, thank you so much for sharing this research. We appreciate it.
Philips: You're very welcome. Thank you for having us.