Global diversification in bonds is just as important as it is in equities. Restricting your exposure to a single market is a risk for which you might not be compensated, writes Steve Garth.
Every night on TV, a talking head runs down what happened on share markets that day. But we rarely hear what happened in the bond market.
This is despite Australian investors typically having anywhere between 40 and 60 per cent of their savings invested in fixed income.
The average investor probably thinks of fixed interest like a term deposit or at best an investment in Australian government bonds.
In reality, this is a global asset class – about twice the size of equities – with multiple opportunities for diversification.
Because of the difficulties for retail investors in participating fully in fixed income, bonds are best accessed through a unit trust that taps into a broad spectrum of economies, issuers, maturities and credits.
By spreading risks in this way, investors can generate good returns and reduce volatility, without sacrificing liquidity or capital protection.
The role and risks of fixed income
Fixed income can play a number of roles depending on investor need.
These include preserving capital, providing liquidity, earning a premium over cash, tempering portfolio volatility, hedging future liabilities and protecting against inflation.
As the name suggests, income is also a major attraction of fixed income, although as we saw in the global financial crisis, it can be problematic to chase income at the expense of maintaining liquidity, diversification or preserving capital.
To understand the roles of fixed income, you need first to accept that there are risks just as there are with equities.
Those broadly come down to maturity risk (the risk of lending out your money for a long time) and credit risk (the risk of the borrower defaulting, or at least the perception of that risk increasing).
The level of maturity risk can be seen in the yield curve.
this refers to the trajectory drawn by charting securities of the same credit risk across different maturities.
In a normal upwardly sloping yield curve, longer-dated securities offer a higher yield than shorter-dated ones. This is to compensate investors for the risk that rising inflation will eat up the value of their investment.
But it is not unheard of for a yield curve to be inverted. This is when shorter-dated securities offer yields above those of longer-dated bonds.
When this happens, it usually reflects a view that the economy is slowing, inflation pressures are easing and interest rates will have to come down. So in recent times, for instance, the Australian yield curve has been inverted.
Likewise, news can drive changes in credit risk. This can be due to changing perceptions about the creditworthiness of individual issuers.
It can also be affected by a more general change in risk appetites.
As news happens, bond prices rise or fall. A rising price means a falling yield, just as a falling price means a rising yield.
That makes sense because if you are paying more for a bond, your expected return will be less.
So in recent times, with investors extremely risk averse, they have been prepared to pay a large premium for the perceived safety of the most highly rated government bonds.
That high price equates to historically low yields. But yields are not low everywhere and this is why you diversify.
The composition of the bond market
Excluding securitised issues, the global bond market is worth a little over $90 trillion. About 80 per cent of the investment grade market is made up of government bonds, with the rest represented by corporate issuers. (See Chart 1)
In terms of issuers, Europe and Japan each make up just under a quarter of the total, while the US represents a little more than that.
As an issuing country, Australia is a very small source of bonds, representing less than 2 per cent of the benchmark. Refer to Chart 1.
Diversifying across countries
In the share market, we can the dampen volatility of our portfolio by diversifying across stocks, sectors and countries.
The same principle applies in fixed income, although in this case the diversification is across maturities, types of issuers, countries of issuer and credit ratings.
Putting all your fixed income allocation in, say, Australian Commonwealth government 10-year bonds is an undiversified bet.
A single poor inflation figure or a blow-out in the government’s deficit could materially affect your investment.
You can ameliorate this risk by diversifying across different yield curves, by taking on some corporate as well as government exposure, by diversifying within corporates and by varying maturities depending on the opportunities on offer at any one time.
Diversification works because of low correlations.
This is just another way of saying that as one market ‘zigs’, another one ‘zags’. Spreading your risk lowers the volatility of your portfolio without significantly affecting the return.
Chart 2 shows the correlation of changes in short-term yields in the Citigroup World Government Bond Index over two periods.
That these correlations are all substantially less than 1.0 tells you that bond markets move differently.
That means there is an opportunity to diversify and harvest premiums using market information. Refer to chart 2.
Diversifying across term structures
Not only are short-term yields uncorrelated across countries, so are term structures. This creates another opportunity for diversification.
Chart 3 shows four different developed market yield curves, the first in original currency terms and the second after hedging back returns to the Australian dollar.
Curve A is an inverted curve and looks a little like the Australian yield curve of recent months.
On an unhedged basis, this curve looks like it offers the highest returns.
But once you hedge back these curves to Australian dollars (using rolling one-month and three-month forward contracts), curves C and D look better. Refer to Chart 3.
What currency hedging does is to pin your starting point to the Australian cash rate, which as we know has been substantially higher than benchmark rates in most of the other developed economies.
So instead of being tied to one yield curve, you have many to choose from.
And this diversification helps you to manage risk in a way that can increase your portfolio’s return while dampening its volatility.
Chart 4 is a comparison of three bond portfolios – an Australian-only one and the Citigroup World Government Bond Index on an unhedged and hedged basis. We make the comparison over the 1-3 year maturity and the 1-5 year.
The return period is 25 years from the mid-1980s to the end of 2011.
You can see that by diversifying globally and hedging back returns to the $A, average monthly returns rise AND volatility falls, by at least a third. Refer to Chart 4.
Conclusion
The global fixed income market is very large. It can be analysed by country of issuer, type of issuer, term structure, credit quality and a range of other factors.
Global diversification in bonds is just as important as it is in equities. Restricting your exposure to a single market or type of issuer or maturity can mean taking unnecessary risks for which you might not be compensated.
A preferred approach is to take maturity and credit risk in line with your own investment objectives.
This can be achieved through the disciplined, transparent and globally diversified approach of a managed fund.
Steve Garth is a portfolio manager in Sydney at Dimensional.
