The benefits of hedged diversification

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.