Aidan Geysen* says Australian investors may need reminding of the enduring diversification and risk reduction benefits of an allocation to global bond markets.
Photo: Duangphorn Wiriya
Australian investors often have a strong bias to domestic equities and property (lacking diversification both across and within asset classes), while cash is often favoured as a defensive asset class over fixed income.
Self-managed super fund (SMSF) research shows most self-directed portfolios have no (or a very low) allocation to bonds.
Further, fears of interest rate rises are an even greater barrier to adding fixed income exposure.
And so many investors may need reminding of the enduring diversification and risk reduction benefits of an allocation to global bond markets.
Investing in bond markets outside Australia may seem to some investors like it might add risk.
In fact, exposure to multiple markets can add diversification and reduce market-specific risk factors, with hedging important to eliminate movements in local currencies.
This is because factors influencing the Australian bond market may not apply to other bond markets (and vice versa), so adding global bond market exposure can smooth returns over time.
This is diversification that can help investors reduce portfolio volatility and risk.
When investors make an allocation to global bonds, they gain more than just exposure to wider securities versus investing only in local bonds — they also get access to other markets’ distinct inflation, economic environments and cycles.
Smoothing of returns
This is important as even though bonds from an overseas market might be more volatile compared with Australian fixed interest, a portfolio that includes bonds of all markets benefits from their diverse characteristics — with the end result being a smoothing out of returns over time.
To analyse how different bond markets compare (and to understand what risks or gaps a purely domestic investment might have), you can break the global investment grade bond market into sectors, bond maturity, quality (ratings) and currency.
This breakdown highlights the case for a broader allocation to international bonds given the Australian bond market is overweight in Government, banks and higher credit quality issues, and underweight in long-duration maturities and the industrial sector.
Bonds perform differently to equities in a portfolio and they potentially offer risk and volatility reduction, which can protect potential losses to a portfolio when equity markets are in decline.
Like bonds, cash may display a low correlation to equities.
Unlike bonds, cash is better suited as a short-term vehicle for liquidity or savings rather than a longer-term investment.
A very important consideration when investing in overseas bonds is currency risk.
It is generally accepted that hedging currency in international bond exposures is critical to maintaining their risk-and-return properties while allowing them to play the traditional diversification and risk-reduction role.
This function of hedging is especially important when share prices are falling during periods of market stress.
How much to hold
Those closer to retirement, as well as those who are just more risk-averse, may have some or a greater allocation to fixed income already.
But bonds are not just for the retiring and risk-averse.
And global bonds should arguably hold a more prominent position in a well-diversified portfolio than domestic bonds.
A good rule of thumb is to follow market size proportions.
Australia accounts for around 2 per cent of global Government and credit bond markets.
Vanguard’s research shows that including an allocation to international bonds significantly expands an Australian investor’s portfolios diversification and opportunity set, without decreasing its total return.
Despite low bond yields, longer-dated bonds still provide investors with additional compensation over and above the cash rate.
While bonds can experience low to negative returns, the reinvestment of a higher coupon and the benefit of compounding means that investors with a medium-to-long timeframe are eventually better off holding bonds, even when rates rise.
Allocations in the portfolio should align closely to investors’ long-term objectives and be adjusted according to their risk profile, and hedging should not be overlooked.
This is general advice only.
* Aidan Geysen is head of investment strategy at Vanguard Australia and an AFR contributor.
This article first appeared at www.afr.com.
