(PUB) Investing 2016

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Solid long-term performance and diversification
from U.S. bond and equity markets have made the
world-bond fund Morningstar Category one of
the fastest-growing categories that Morningstar tracks.
Because of the wide variety of approaches (un-
hedged versus U.S. dollar-hedged, global versus non-
U.S., broad-based versus single-sector), funds within
the category have a large range of risk exposures.
It makes most sense to divvy up the category by various
approaches to currency management rather than
by credit, regional, or sector focus, as currency move-
ments have the most significant impact on risk/
return profiles. World-bond funds tend to follow one
of three currency management approaches: unhedged,
tactically hedged, and U.S. dollar-hedged.
Tactical: Nearly 60% of world-bond funds employ a
tactical approach to currency hedging as of December
2015. The managers of these funds actively manage
exposure to non-U.S.-dollar currencies through
currency forwards or futures. Some of these funds’
managers will make modest adjustments to these
exposures relative to an index, while others rely
more heavily on currency to add returns. In the latter
case, managers will often hold net short positions
to individual currencies or will have a positive view on
a currency but not own any underlying bonds.
Most in this subgroup are focused on a combi-
nation of government and corporate debt, with the
Barclays Global Aggregate appearing as the most
common benchmark. The government-only Citi World
Government Bond Index is also prevalent. More
than two thirds of these funds have a global purview;
the remaining funds exclude the United States.
Unhedged: Around one fourth of active and passive
world-bond category funds leave their overseas
currency exposures completely unhedged and, as a
result, carry the most currency risk among the three
subgroups examined here. From a regional standpoint,
half the group focuses on non-U.S. debt while the
rest have a global purview. More than half of these of-
ferings focus mostly, if not solely, on government
debt. A smaller subset focuses on global or non-U.S.
corporates, and just a few are dedicated to global
inflation-linked bonds. Therefore, funds in this cohort
sport varying levels of interest-rate and credit risk.
Hedged: The smallest subset (17% of world-bond
funds) comprises funds that fully hedge currency expo-
sures back to the U.S. dollar. These funds focus
on Treasuries or a mix of Treasuries and corporates,
and there are no dedicated high-yield or inflation-
protection strategies in the group. Here investors forgo
currency risk, with hedged versions of the Barclays
Global Aggregate and the Barclays Global Aggregate
ex-U.S. serving as common benchmarks.
Our Top Picks
Unhedged world-bond funds are the most volatile of
the three category subgroups, largely because of
currency movements, so investors need a higher risk
tolerance. PIMCO Foreign Bond Unhedged PFBDX
has experienced nearly twice the volatility (as
measured by standard deviation) as its hedged sibling
over the past decade through December 2015.
Given that tactical funds court at least some currency
risk and many, including Templeton Global Bond
TPINX and Loomis Sayles Global Bond LSGLX , have
large helpings of emerging-markets debt, it
follows that the tactical group has been closer to the
unhedged cohort in experiencing higher levels of
standard deviation and steeper sell-offs in downdrafts.
By contrast, hedged world-bond funds including
PIMCO Foreign Bond USD-Hedged PFODX and
Vanguard Total International Bond Index VTIBX have
standard deviations more akin to those of the
Barclays U.S. Aggregate and other U.S. government
debt indexes. Investors looking to diversify equity
risk should consider this subgroup as it has displayed
lower correlations to the S&P 500 over time. K
Contact Karin Anderson at
Currency Is Key in World-Bond Funds
Income Strategist | Karin Anderson