With bond yields across the globe expected to remain low, some clients are questioning the diversification benefits of global fixed income. But, it would be a mistake to pull back based on recent market trends.
Let’s look at global monetary policies. While they’ve been extremely aggressive for the most part, central bank policies should diverge over the next several years. The burdens on monetary policymakers are heavy and varied, ranging from raising rates at the right time and pace (U.S. and U.K.), to engineering a soft landing for credit growth (China), to ensuring appropriate balance-sheet expansion (Eurozone and Japan), to managing the impact on currencies of global monetary policies (Canada, Australia and Switzerland).
We believe the Federal Reserve will keep short-term rates near 0% through mid-2015, and the Fed’s rate increases will be more gradual (moving in smaller increments or pausing). But for many major developed economies, real (inflation-adjusted) short-term interest rates are likely to remain negative through, at least, 2017. The ECB and Bank of Japan may be hard-pressed to raise rates this decade. Over the last few months we’ve had low rates in the rest of the world, somewhat higher yields in the U.S., and the U.S. dollar getting stronger. In response, investors have been stockpiling U.S. Treasuries, while chasing higher yields and U.S. dollar trends.
Under these conditions, a broadly diversified global bond portfolio still makes sense.
It’s important not to focus just on lower global rates; you also need to consider the Canadian dollar. Comparing interest rates across countries is meaningless without factoring currency. Even for currency-hedged fixed-income investments, the currency hedge’s return must be added to global bond yields before comparing them to domestic yields. The hedge return is the currency return that arises from locking in a future CAD exchange rate through the currency hedging contract.
Over longer investment horizons, hedge returns should reach an average that will roughly offset any yield differential between domestic and international bonds. Hence, low-yielding global bonds are not at a disadvantage out of the gate, since they’re expected to earn a positive hedge return over time. Over shorter time periods, hedged return differentials are driven mainly by interest-rate movements at home and abroad. It seems natural to think divergent monetary policies right now should lead to rising rates and capital losses in the U.S. and U.K., along with falling rates and capital gains in Europe, Canada and Japan. However, when it comes to movements in long-term rates, monetary policy is just one element; other important factors include inflationary expectations, economic growth, fiscal policies, international capital flows and investor risk aversion.
For instance, it’s possible the ECB’s recent QE initiative gains more traction than expected. In that case, markets would be surprised by a better-than-expected recovery and rising inflationary expectations in Europe. Also, longer term rates could actually rise in Europe. Similarly, the BoC’s recent rate cuts may over time lead to inflationary expectations and an uptick in longer-term rates. Or, unexpectedly weaker economic data over the next few months could lead the Fed to delay rate increases or follow a more gradual path than currently expected.
Diversification makes sense because it’s uncertain which scenario will play out. Bottom line: the benefits of global fixed-income in a balanced portfolio should persist during the period of divergence in global central bank policies.
by Roger Aliaga-Diaz, senior economist, Vanguard Investment Strategy Group.