asset allocation | may 16, 2024
The benefits of hedged diversification
Non-U.S. bonds currently offer higher yields on a currency-hedged basis.
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Investment-grade bond returns for U.S. investors have been subpar over the past year, with the Bloomberg U.S. Aggregate Bond Index posting a negative return of -0.83% over the year ended April 23, 2024.
This loss was primarily due to rising interest rates, which were driven higher by stubborn inflation and a consequently more hawkish U.S. Federal Reserve. Over the same period, the 10-year U.S. Treasury yield increased from 3.53% to 4.59%.
U.S. investors who diversified their bond exposure to include non-U.S. investment-grade bonds also have suffered. Over the year ended April 23, the Bloomberg Global Aggregate ex-USD Bond Index posted almost a 3% loss. But this subpar performance was primarily due to the strength of the U.S. dollar, as the currency translation effect negatively affected returns on bonds denominated in other currencies.
For those investors who chose to diversify their bond exposure with currency-hedged non-U.S. bonds, the results were much more satisfying. Over the same time period, the currency-hedged version of the Bloomberg Global Aggregate ex-USD Bond Index returned a positive 5.59%.
And there are reasons to believe this trend could continue. Notably, many global bonds currently offer superior hedged yields relative to their U.S. counterparts. Additionally, interest rates outside of the U.S. could be poised to move in a more favorable direction, as many non-U.S. central banks are widely expected to cut interest rates more than the Fed during the remainder of 2024.
Non-U.S. bonds currently offer higher yields on a currency-hedged basis
U.S. bond yields generally are higher than the yields in other developed markets. We can observe this by comparing 10-year sovereign bond yields across various countries. Almost all developed market yields are lower than the U.S. yield in local currency terms.
But this is not the case when the benefits of U.S. dollar hedging are factored in. By hedging their local currency exposure, U.S. dollar-based investors can increase the effective yield on nondollar bonds. Once this is factored in, the picture changes considerably—giving many non-U.S. sovereigns a yield advantage on a hedged basis.
Non-U.S. bonds may offer better duration exposure*
The direction of interest rates outside of the U.S. also could prove more favorable for bond investors. This is because inflation appears to be less of a concern in many other countries.
For instance, while the U.S. inflation expectations have risen steadily so far in 2024, inflation expectations for the eurozone have fallen modestly. As a result, the European Central Bank has less reason to keep interest rates at their current levels, whereas the Fed may be forced into a “higher for longer” stance until inflation expectations begin to moderate.
These divergent paths can be illustrated by examining futures market pricing for the Fed versus the ECB. On January 12, 2024, futures markets priced in a 1.68 percentage-point reduction in the U.S. federal funds rate by the end of the year, while the ECB was only expected to cut by 1.53 percentage points over the same period. But, as of April 23, the Fed was expected to cut by only 0.44 percentage points, while the ECB was expected to cut by 0.76 percentage points.
Conclusion
Given the currently superior effective yields on hedged nondollar bonds, and more promising expectations for non-U.S. developed market central bank rate cuts, our Asset Allocation Committee recently increased its exposure to hedged non-U.S. bonds in our U.S.-based multi-asset portfolios.
*Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa
Key Insights
Higher yields on hedged non-U.S. dollar bonds and better expectations for rate cuts by non-U.S. developed central banks have created diversification opportunities for U.S. dollar-based investors.
Our Asset Allocation Committee recently raised exposure to hedged non-U.S. bonds in our U.S.-based multi-asset portfolios.
Investment-grade (IG) bond returns for U.S. investors have been subpar over the past year, as stubborn inflation and a more hawkish U.S. Federal Reserve have pushed yields higher. The Bloomberg U.S. Aggregate Bond Index returned -0.83% over the year ended April 23, 2024.
Non-U.S. IG bonds also have suffered, with the Bloomberg Global Aggregate ex-USD Bond Index (Global Agg ex-USD) returning -2.82% over the year ended April 23, 2024. However, this loss was primarily due to a strong U.S. dollar. On a U.S. dollar-hedged basis, the Global Agg ex-USD posted a positive 5.59% return.
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There are reasons to believe these relative performance trends could continue.
Although U.S. bond yields generally are higher than yields in other developed markets currently, by hedging their foreign currency exposure, U.S. dollar‑based investors can increase the effective yields on nondollar bonds—giving sovereign bonds in many non-U.S. developed markets a yield advantage over U.S. bonds (Figure 1).
Non-U.S. bonds also may offer better duration1 exposure if interest rates fall more rapidly in other developed markets.
Non-U.S. bond yields are higher on a hedged basis
(Fig. 1) USD-hedged 10-year sovereign yields in key developed markets
As of April 23, 2024.
Past performance is not a reliable indicator of future performance.
Source: Bloomberg Finance L.P.
U.S. inflation expectations have risen since the start of 2024, which could force the Fed to hold rates “higher for longer” (Figure 2). But expectations for eurozone inflation have declined modestly. This means the European Central Bank (ECB) may have less reason to keep rates at current levels.
Other central banks appear more likely to cut rates
(Fig. 2) Expected 2024 rate reductions priced in to futures markets
December 31, 2023, through April 23, 2024.
Actual outcomes may differ materially from forward estimates.
Source: Bloomberg Finance L.P.
As of early January, futures markets were pricing in a 1.68 percentage point reduction in the Fed’s key policy rate—the federal funds rate—by the end of 2024 (Figure 2). The ECB was only expected to cut rates by 1.53 percentage points.
By April 23, however, markets only expected the Fed to cut rates by 0.44 percentage points before the end of 2024. The ECB, meanwhile, was expected to cut rates by 0.76 percentage points.
Given the currently superior yields on hedged nondollar bonds, and more promising expectations for rate cuts in other developed markets, T. Rowe Price’s Asset Allocation Committee recently raised exposure to hedged non-U.S. bonds in our U.S.-based multi‑asset portfolios.
Past performance is not a reliable indicator of future performance.
1Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
Additional Disclosures
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Important Information
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of May 2024 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Actual outcomes may differ materially from any forward‐looking statements made.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. Derivatives that may be used for currency hedging may be riskier or more volatile than other types of investments because they are generally more sensitive to changes in market or economic conditions; risks include currency risk. They may be subject to higher fees and a perfect hedge may not be achieved. Diversification cannot assure a profit or protect against loss in a declining market. All charts and tables are shown for illustrative purposes only.
T. Rowe Price Investment Services, Inc., distributor, and T. Rowe Price Associates, Inc., investment adviser.
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