Sources of return for hedged global bond funds

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1 Research commentary Sources of return for hedged global bond funds August 2012 Author Roger McIntosh Executive summary. The recent results in key bond market indices demonstrate the importance of a strategic, diversified approach to asset allocation particularly when considering the role of bonds in a balanced portfolio. Yields for high quality bonds have fallen over the last 12 months as investors sought safer havens from the uncertainty surrounding the European debt crisis. It has also resulted in aggregate returns for bond portfolios being significantly higher than cash/term deposit rates. This note examines the sources of returns for hedged global bond portfolios. It demonstrates that, in addition to evaluating the yield to maturity, an analysis of the holding period return and the role of yield pickup are important in assessing the return in hedged Australian dollar terms. The paper also looks at the benefits of implementing a diversified approach across domestic and hedged global bonds to a fixed income allocation. Connect with Vanguard The indexing specialist > vanguard.com.au >

2 Sources of return for hedged global bonds The importance of maintaining a strategic, diversified approach to all components of asset allocation, defensive and growth, has been demonstrated in the recent results for several key domestic and global bond benchmarks. Figure 1 summarises return and total risk data of key local and global bond benchmarks over the last 12 months to 3 years. As at the end of 30 June 2012, the 12 month return provided by each of the fixed interest strategies were significantly higher than the Bank Bill Index, or what would have been provided from holding term deposits. The typical special rate term deposit achieved around 5.5% and the average 6 month term deposit returned around 4.5%. Why have bond returns been comparatively strong? There are several contributing factors: The general downward shift in yield curves across most government issuers as the market uncertainty over the European debt crisis increased demand and hence prices for high quality government bonds and the yield pickup that arises from the Australian dollar hedge. The change in yield levels demonstrates duration to be one of the drivers of return that exists in bonds and not cash instruments. returned 7.3% for the 12 months ended 30 June 2012 with total risk of 16% Over three years it would have returned -2.4% with total risk of 13% Looking beyond yield to maturity It is also important to consider all the return components when evaluating a hedged foreign currency bond fund and not to be distracted by the headline yield to maturity. An investment in a foreign currency denominated bond plus the currency hedge must have the same value of an equivalent local currency bond investment for the same term and credit quality. Any divergence would violate covered interest rate parity and present arbitrage opportunities. The main sources of return for a hedged bond portfolio arise from: a. Coupon accrual. b. Changes in bond value from term structure shifts (where the yield curve moves or changes shape; or yield spreads for non-government bonds change). c. Hedge yield pickup (the forward premium from the difference between Australian and non-australian short-term cash rates in the currency hedge). Implementing a currency hedge means that the portfolio of global bonds exhibits similar levels of total risk to domestic bonds and provides a diversified source of fixed interest risk. Not hedging the currency exposure creates levels of total risk consistent with an equity portfolio and produces a currency return fund as the volatility of the currency movements are much larger than the volatility of the underlying bonds. To provide a comparison, an AUD unhedged Global Treasury portfolio would have Figure 1. and total risk data of key local and global bond benchmarks Period ended 30 June 2012 Barclays Global Treasury Index Barclays Global Agg Govt Related & Corp Index UBS Composite Index UBS Bank Bill Index Ave. Term Deposit * 1 year 11.9% 3.0% 11.7% 3.1% 12.4% 3.8% 4.7% 4.5% 2 years 8.8% 3.0% 10.0% 2.9% 8.9% 3.3% 4.8% 4.5% 3 years 9.0% 2.7% 11.4% 2.8% 8.6% 3.0% 4.5% 4.1% Sources: Barclays, UBS and RBA * Compounded return based on RBA observed 6 month Banks term deposit rate, reinvested every 6 months. 2

3 Example Yield to Maturity (% ) Figure Source: FactSet US Treasury yields Term (years) Barclays US Treasury Index Number of securities yrs Average coupon: 2.84% Average yield to maturity: 1.73% Number of securities: yrs Average coupon: 2.38% Average yield to maturity 0.92% Barclays Global Treasury Index Number of securities: 1, yrs Average coupon: 3.00% Average yield to maturity: 2.22% Number of securities: 1, yrs Average coupon: 2.74% Average yield to maturity: 1.51% Barclays GA Govt. Related & Corp. Index Number of securities 10,663 Modified Duration: 5.22 yrs Average Coupon: 4.45% Average Yield to Maturity: 3.32% Number of securities: 10, yrs Average coupon 4.26% Average yield to maturity: 2.71% We can demonstrate with an example of the holding period return for hedging a portfolio benchmarked to the Barclays US Treasury Index, which is a broad portfolio of bonds in a single currency. To provide some context, the graph in Figure 2 sets out the US Treasury yield curve as at the end of June 2011 and The yields have reduced more for longer dated maturities than shorter dated maturities, a flattening movement. Over the 12 months to 30 June 2012, the values of each of the components (a, b and c) of the index return are: a. Coupon return: 2.5% b. Price change: + 6.5% c. Yield pickup (carry): + 4.3% = AUD Hedged : 14.4% The yield pickup reflects the average interest rate differential between AUD and USD short-term rates that is earned from the currency hedge as Australian dollar short term rates are higher than US dollar short term interest rates. Currently the yield pickup is around 3.5% due to the reduction in the Australian overnight cash rate in recent months. This logic also extends to a multi-currency framework and estimates of the components of return for the Global Treasury Index and the Global Aggregate Government Related & Corporate Index. For the 12 months to 30 June 2012, the total return shown in Figure 2 for each index is broken down as: Barclays Global Treasury Index a. Coupon return: 2.7% b. Price change: + 4.6% c. Yield pickup (carry): + 4.6% = AUD Hedged return: 11.9% Barclays Global Aggregate Government Related & Corporate Index a. Coupon return: 4.3% b. Price change: + 3.3% c. Yield pickup (carry): + 4.1% = AUD Hedged return: 11.7% 3

4 A breakdown of the sources of return reveals certain characteristics for each index. The Treasury index has a longer duration, due to most governments ability to borrow for longer terms compared to nongovernment entities. The Government Related and Corporate Index has a higher average coupon than the Treasury Index, reflecting the higher risk and possibility of default for non-government entities. Compared to the Government Related and Corporate Index, the breakdown of the Treasury Index return shows a lower amount from coupon, but more from price change as the average yield to maturity changed by a larger margin (71b.p. compared to 51b.p.) on a portfolio with greater price change sensitivity. The yield pickup for each index was similar, with differences arising from the currency weighting of each index. The yield pickup is a weighted average of the short term interest rate differentials for each of the currencies being hedged back to the Australian dollar. As at the end of June 2012, the yield pickup for both global indices was approximately 3.1%. The correlation between domestic and global bonds has been stable for many years and the 40% allocation to domestic bonds is an approximation of the allocation that can provide the minimum total risk. The benefit of a diversified approach is that the total risk of the portfolio is lower than the average total risk of the individual components. Diversification across domestic and global bonds can also continue to provide income during periods when the global bond fund does not distribute (which can occur due to the interaction between hedging profit and loss and coupon income) and it reduces the likelihood of negative returns over the short run. There have been periods when interest rates have risen and where in the short term the return for cash exceeded the diversified approach. However, a longterm approach as shown over the ten years to 30 June 2012 has produced an outcome that consistently achieves the results of stable returns that are greater than cash and produces steady income and low volatility. It is important not to evaluate the suitability of a global bond portfolio merely from the observed yield to maturity of the constituent foreign instruments, as the long run return in hedged Australian dollar terms reflects multiple components which combine to provide the holding period return. The benefits of a diversified approach to bond allocations The value of holding global bonds is most clearly demonstrated in the context of a diversified portfolio of domestic and global bonds. A portfolio that held an allocation of 40% Australian bonds (UBS Composite Bond Index) and 60% global bonds AUD Hedged (Barclays Global Aggregate ex Securitised a market-capitalisation-weighted combination of the Treasury and non-treasury bond indices) would have provided the outcome as seen in Figure 3 below. Figure 3. and risk of a diversified portfolio Period ended 30 June 2012 Total return () Margin over Bank Bill Index (bp) () 1 Year 12.0% 7.3% 2.6% 2 Years 9.1% 4.3% 2.6% 3 Years 9.3% 4.8% 2.4% 5 Years 9.0% 3.6% 2.6% 10 Years 7.7% 2.2% 2.7% Sources: UBS, Barclays, calculations by Vanguard Investments Australia Ltd 4

5 References Hunter, D. and D. Simon, Benefits of International Bond Diversification, The Journal of Fixed Income, March 2004, Vol. 13 No. 4, pp Leibowitz, M.L, L.N. Bader and S. Kogelman, Global Fixed Income Investing: The Impact of the Currency Hedge, The Journal of Fixed Income, June 1993, Vol. 3, No. 1, pp

6 Connect with Vanguard The indexing specialist > vanguard.com.au > For Financial Advisers only. Not to be given to retail investors. The dollar value cost savings are calculated using historical index performance. Past performance is not an indication of future performance. Annual index returns assume 100% reinvestment of income with no capital withdrawals and takes no account of entry and exit fees and taxes. The results would be different if alternative indices were chosen or if the survey of managers considered different or more funds. This paper includes general information and is intended to assist you. Vanguard Investments Australia Ltd (ABN / AFS Licence ) is the product issuer. We have not taken your circumstances into account when preparing the information so it may not be applicable to your circumstances. You should consider your circumstances and our Product Disclosure Statements ( PDSs ) before making any investment decision. You can access our PDSs at vanguard.com.au or by calling Past performance is not an indication of future performance. This publication was prepared in good faith and we accept no liability for any errors or omissions Vanguard Investments Australia Ltd (ABN / AFS Licence ). ICRAUSRHGB

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