The benefits of hedged diversification
Non-U.S. bonds currently offer higher yields on a currency-hedged basis
May 2024, From the Field
May 2024, From the Field
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.
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.
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.
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.
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.
There are reasons to believe these relative performance trends could continue.
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.
As of April 23, 2024.
Past performance is not a reliable indicator of future performance.
Source: Bloomberg Finance L.P.
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.
Recession fears are fading, but inflation concerns are on the rise.
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