Breaking down borders in corporate bond markets
Over the last twenty years, the size of the global corporate bond market in the developed world has risen eight-fold1, fuelled by globalisation, falling interest rates and increased capital flows. Yet investors have shown a marked reluctance to diversify their investments globally. Indeed, in 2016, domestic bonds still accounted for 77% of the average pension fund bond portfolio2. Seemingly many investors prefer local markets for currency reasons and/or see overseas markets as riskier. In contrast, we believe that there are significant benefits to investing abroad, but certain key considerations need to be kept in mind.
Investors often focus on starting yields as a guide to long-term returns. However, they need to be aware that currency hedging erodes some of the differences between foreign and domestic returns, rendering comparison of starting yields across markets less meaningful.
Nevertheless, our research has found that there are key benefits to be gained from going global, including both diversification and better risk-adjusted returns. Whilst some may question the point when currency hedging brings global bond returns into line with local bonds, we would argue that performance should not be the only consideration. Reducing volatility, improving portfolio efficiency and avoiding sharp valuation moves are just as important. Moving abroad can help with all three.
Volatile markets can make entry and exit opportunities difficult. But by investing in overseas markets with lower volatilities the resulting diversification can decrease portfolio risk over the long-term and generate a smoother return profile. An importance consequence of lower volatility is its impact on risk-adjusted performance. While some local markets may offer higher long-term returns, these returns may be accompanied by higher volatility. Overseas markets can therefore still be attractive if lower volatility improves risk-adjusted returns, even if absolute returns are lower.
Short-term trends should also affect the decision to diversify globally because there can be substantial differences in regional performance over short time horizons. This is reflected in the wide dispersion of short-term returns shown in our chart below, where performance leadership has rotated significantly on an annual basis. Such are the differences that in 2012 the gap between the top (sterling bonds) and bottom (yen bonds) performance in dollar terms was as much as 13.9 percentage points, yet the following year yen bonds outperformed their sterling equivalents. Investors therefore need to be flexible in allocating assets, given the speed at which performance leadership can change.
All data is in hedged USD terms. Past performance is not a guide to future performance and may not be repeated. Source: BofA Merrill lynch and Schroders. Data to 30 September 2017.
An active approach is clearly desirable. We have modelled how simple active portfolios would have performed over the last 20 years. There were extended periods when investors would have enhanced their performance with a manager who could adjust asset allocations. Moreover, three-quarters of the time, the median active portfolio displayed better risk-adjusted returns than the local market. We believe this underlines the importance of embracing flexibility. And it means that using a manager with the discretion to invest across a range of different regions can help any investor who wants to get the most from global corporate bonds.
1. As reflected by the BofA Merrill Lynch Global Corporate Index. ↩
2. Average across US, UK, Switzerland, Netherlands, Japan, Canada, Australia, according to Global Pension Assets Study, Willis Towers Watson, 2017. ↩