The Fed may have left well enough alone for now, but in our view it won’t leave the pot to simmer much longer. US interest rates are going to rise, almost surely before the year is out. Thankfully, diverging interest-rate cycles around the globe offer hope—and opportunity—for US investors.
As US rates begin their upward climb, US investors are understandably worried about their bond returns. But bonds will remain a critical component of any portfolio, providing investors with steady income and helping to offset the greater volatility of investors’ equity market exposure. So what’s a US investor to do?
Add global bonds. A globalized portfolio is more effective at meeting income and anchor-to-windward goals than a domestic-only one because it diversifies interest-rate and economic risks while also increasing the opportunity set.
Say Yes to Global Bonds…
Different growth rates, interest-rate cycles and economic policies in other countries and regions mean both increased diversification and more opportunities to boost returns. In fact, this may be an especially good time to take advantage, as the US begins to chart a separate course.
The European Central Bank has signaled that it’s likely to extend its bond-purchase program beyond September 2016. And the Bank of Japan is also likely to continue its own asset-buying program; at the most, it may be on the cusp of tapering it, should Japan’s economy continue to grow slightly above trend. Meanwhile, with rising unemployment and falling commodity prices in Australia, further policy easing there seems possible.
Broader exposure to these and other non-US markets has historically helped buffer the downside risks that US-centric portfolios experience as rates rise. Between 1990 and 2014, we found that the Barclays Global Aggregate Bond Index, hedged to US dollars, captured 95% of the average quarterly returns posted by the Barclays US Aggregate Index when that index was in positive territory, but only 67% of its average quarterly loss.
In other words, investors who shifted away from the US toward countries where rates were falling, steady or rising more slowly than those in the US preserved more of their capital.
…but No to Global Currencies
Divergent global monetary policies don’t affect just interest rates. They also influence currencies. Stronger US growth and the accompanying expectations for rate hikes have already boosted the dollar. For the same reasons, many investors will continue to want income from their bond portfolios in dollars, rather than euros, sterling or yen. That means hedging out the currency risk. Doing so is easy and cheap, thanks to currency forwards and futures.
For US core-bond investors, it’s worth the effort. Exposure to a variety of global currencies increases bond portfolio volatility. In fact, currency-hedged global bonds have been consistently less volatile than both an unhedged global portfolio and a US-only one, as we’ll explain in greater detail in a future post.
Uncertainty is common at the start of a rate-rise cycle. By adding global bonds—while hedging currencies—investors are more likely to enjoy stability and peace of mind in the months to come.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.