The slow downturn in interest rates is insufficient to diminish the role of bonds in an investment portfolio, but those choosing to invest offshore should hedge any currency risk to avoid amplifying market volatility, according to Vanguard global chief economist Joe Davis.
Speaking at a recent adviser briefing in Sydney, Davis said global economies were in a period of real interest rates, which had been adjusted for inflation, that ran counter to long-term expectations, but suited fixed-income investors.
“Ever since the global financial crisis, most markets had zero or negative interest rates with the expectation that wasn’t going to change,” he stated.
“Why am I going to take duration risk when I have negative real rates? A lot of people didn’t think we would ever exit that situation.
“Our frameworks said fiscal policy will start to push things up and that’s increasingly evident because when you have real short-term or long-term interest rates, it’s a very compelling case for fixed income.”
He said ongoing commentary around the United States Federal Reserve or Reserve Bank of Australia (RBA) cutting interest rates did not change his view bonds were still important as rates were unlikely to fall substantially.
“Rates are going to move around this sort of level. You’re going to have the US Federal Reserve easing cycles and tightening cycles and the RBA can make another cut, but those are little cycles around the trend,” he said.
“Our point is the trend is higher. That’s why bonds are back because real interest rates are positive and this is the more normal environment, but we haven’t lived in it for 15 years.”
Investors looking for fixed-income investments in overseas market should hedge their currency risks, he added.
“The whole basis for going outside of Australia is because we’re trying to diversify exposure to yield curves. In any part in the world, there’s different shapes of yield curves between the US, Germany or Japan,” he said.
“You don’t want to introduce currency risk unless you have some sort of tactical view or overlay and mixed currency overlays with a fixed-income portfolio means you’re talking about twice the volatility.
“In fact, you are introducing equity-like volatility to a fixed-income mandate, even more so with high-yield bonds.
“That’s a way to think about it. I would be doing it as a hedging ratio if you have that approach on the equity side more than on the fixed-income side because the case for diversification goes out the window if you are not hedging currency risk.”
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