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The Global Bond Paradox: How Hedging Can Enhance Low Local Yields

Despite low bond yields in many countries outside the U.S., hedged yields may be quite attractive for U.S. dollar-based investors.

Japanese government bonds yield virtually zero. Yields on German bunds remain stuck below 50 basis points (bps). U.K. gilts yield only about 125 bps. Do non-U.S. bonds such as these hold any value to dollar-based investors?

Yes, quite a bit, it turns out.

For a dollar-based investor, hedging foreign currency exposure on lower-yielding global bonds may potentially result in higher yields than U.S. Treasuries. Essentially, investors are getting paid to hedge the currency risk back to the US dollar. Other potential benefits for those who invest internationally and hedge their U.S. currency exposure include improved diversification and defense against rising U.S. interest rates.

Why hedging may pay

Despite low bond yields in many countries outside the U.S., hedged yields may be quite attractive for U.S. dollar-based investors. The yield to maturity of hedged global bonds (as represented by the Bloomberg Barclays Global Aggregate Index ex-USD (USD Hedged)) was 3.16% as of 30 June 2018 – nearly equal to the 3.27% for the main U.S. bond index (represented by the Bloomberg Barclays US Aggregate Bond Index).

How is that possible? Hedging foreign currencies back to the U.S. dollar currently adds about 220 bps of carry because of favorable short-term interest rate differentials. In order to hedge currency exposure in a foreign bond, investors effectively pay the short-term rate in the foreign currency and receive the short-term rate in their home currency.

If short-term rates for U.S. dollars are higher than those for the target currency – as they are in many cases today – the cost of hedging may be negative; in other words, investors could get paid to hedge.

We expect this dynamic to continue over the cyclical (six- to 12-month) horizon as the Federal Reserve continues to raise rates while most other developed market central banks remain on hold.

Other potential benefits

The investment case for global bonds is not just about relative yields. Harry Markowitz, a Nobel laureate economist and the father of modern portfolio theory, called diversification “the only free lunch in finance” for its potential to reduce risk without sacrificing returns. Global bonds are a great example of the potential benefits of diversification.

Case in point: Global bonds returns were positive in eight of the past 11 periods of increasing U.S. interest rates (see chart). In the first six months of this year, they delivered a positive return of about 1.4%, while the Bloomberg Barclays US Aggregate Bond Index fell around 1.5%.

Because economic cycles and hence monetary policies are not in perfect alignment globally, diversification into global bonds may reduce portfolio volatility by giving investors exposure to countries with varying yield curves. In a way, because economic cycles vary across countries, there is a natural rotation of best- and worst-performing global bond markets. At times, this may allow global bonds to help dollar-based investors buffer their portfolios from the effects of rising U.S. interest rates.

Even during periods of stress, when correlations between U.S. and global bonds increase, global bond markets may not be perfectly correlated, so diversification potential remains.

In sum, we view global bond strategies like broccoli in your diet – if consumed regularly, they may deliver sustained benefits over time.

The Author

Sachin Gupta

Head of Global Portfolio Management Desk

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London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

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PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Milan
PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the Securities Institutions Act (WplG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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