Overview and Recommendation
In the search for a better risk-adjusted level of returns, investors are seeking ways to increase absolute fixed income return on their investments while reducing volatility. As a fixed income index is typically the benchmark chosen by investors to measure fixed income return, many clients have asked for our thoughts on the suitability of differ- ent benchmarks, particularly when their require- ments are changing.
Well-diversified benchmark indices achieve the highest, risk-adjusted returns. There are two main sources of diversification: cred-
it sector diversification and global diversification.
Credit sector diversification gives
•
investors exposure to broad market sectors, including Treasuries, Mortgage Backed Securities (MBS), Asset Backed Securities (ABS), corporate bonds, emerging market debt and high yield bonds
Globally diversified indices cover global bond
•
markets, giving investors exposure to either government bonds or a mixture of broad market securities
Given that globally diversified portfolios provide the highest level of interest rate diversification, the main question investors ask is whether to hedge their currency exposure. To find an answer, we have looked at the risk/reward characteristics of global indices compared to U.S. dollar indices as measured over 10- and 20-year periods.
The results of our research revealed that unhedged indices produce more volatile returns due to their open currency positions. In contrast, currency hedged indices provide interest rate diversification while removing currency volatil- ity. These conclusions, also applicable for indi- vidual portfolios, were the same for both global government bond indices and global broad mar- ket indices.
We therefore recommend that investors seek- ing global diversification should use a global currency-hedged index as their benchmark.
When examining risk-adjusted total portfolio returns, some currency exposure improves diver-
sification, as currency movements generally have a low correlation with interest rate returns. The optimal mix will vary for different clients, but it is likely to be approximately 70% to 90% hedged into U.S. dollars.
We additionally recommend that asset managers add value to portfolios by using a foreign exchange (FX) overlay strategy relative to their cho- sen benchmark. Any historical analysis to deter- mine the appropriate level of FX hedging tends to be very dependent on the historical period chosen.
From a U.S. dollar perspective, if the period mea- sured represents a time of dollar strength (over and above that captured in the interest-rate dif- ferential), then 100% hedging tends to be the optimum position. However, if the period mea- sured represents significant dollar weakening, then the hedge ratio is very low. For that reason we recommend the 70% to 90% hedge with FX overlay to take advantage of currency movements in the short term.
I N S I G H T S Managing Risk/Reward in Fixed Income
Using Global Currency-Hedged Indices as Benchmarks
In the pursuit of alpha, is it better to use a global hedged or
unhedged index as a benchmark for measuring returns? Here is what our analysis has uncovered:
Global currency-hedged indices
•
provide diversification Unhedged currency indices
•
produce more volatile returns Global currency-hedged indices
•
reduce risk
Our analysis is based on government bond indices, but it also suggests that our recommendations would apply to aggregate indices.
The conclusion: Global currency- hedged indices provide attractive risk-adjusted returns.
Michael Wilson Managing Director Global Applied Risk and Research,
Fixed Income
April 2008
For more information, please contact your JPMorgan representative.
Diversification is
key to increasing
risk-adjusted
returns.
Return %
Risk versus Return, US$ assets, from 1987 to 2007
5.0 5.5 6.0 6.5 7.0 7.5 8.0
1 2 3 4 5 6
Risk % JPM Cash USD
1–3 yr
1–5 yr
1–10 yr
1–30 yr
WGBI US USD
Data: Annualized quarterly returns for index changes from December 1987 to December 2007. Cash Index: JPMorgan Cash Index is based on 12-month LIBOR in USD. Source: JPMorgan and Citigroup.
Exhibit 1: Over time, longer maturity cash indices generate higher returns at greater risk
The case for using global hedged indices as benchmarks
U.S. dollar risk and performance
Our analysis is based on government bond markets as measured by the Citigroup World Government Bond Index (hereafter referred to as WGBI) from December 31, 1987 to December 31, 2007. We chose these indices since the hedged indices data has been measured longer than other equivalent indices from JPMorgan, Lehman Brothers or Merrill Lynch. Exhibit 1 illustrates the his- torical risk and returns for the U.S. treasury component of the WGBI. The chart clearly reveals what we would expect from fixed income markets: over extended time periods longer maturity indices produce higher returns and higher risks.
On a forward-looking basis, we would differentiate between the levels and the slope of the curve. For levels, we would anticipate lower average returns in the future as we expect interest rates will likely be lower over the next 20 years than they have been over the past 20 years for three reasons:
Better inflation management
•
High demand for fixed income securities from
•
sovereign funds and pension funds Moderate issuance
•
We continue to expect higher returns from longer dura- tion assets but probably a gentler slope, as the premium yield for longer-dated assets may be lower in the future.
Volatility of returns
Another way of examining this data is to look at the volatility of returns using actual historical data. Exhibit 2 uses the same U.S. Treasury Index, but shows the range of annual, calendar year returns over the past 20 years.
Exhibit 2 gives rise to a number of points:
As expected, the range of returns is most extreme for
•
a full maturity index with the lowest return of -4%
in the year to September 1994, the highest return of 18% in the year to December 1995.
The range of historic returns is much narrower than
•
for many asset classes, such as emerging market debt or equities.
For investors requiring the lowest probability of
•
negative absolute returns over a 12 month period, a 1
to 3 year index has often been used, but has produced
one period of negative returns in the year to March
2005.
Global bonds
Unhedged indices add risk
Many investors believe that adding global bonds to their portfolios increases risk. In the case of unhedged indices, this concern is very much true, as shown in Exhibit 3.
Although returns from unhedged indices are not mate- rially different (the small difference in returns is due to interest rate differentials and small currency movements during the period), risk has been increased significantly.
This results from a single factor: currency risk is higher than interest rate risk.
Approximately 80% of a typical global government bond index is exposed to non-U.S. bonds. Hence, about 80% of the currency position in an unhedged index may be affect- ed by the rise and fall of the U.S. dollar. Based on internal analysis, we assume 7.5% FX risk is roughly equivalent to one-year of duration risk, the currency position in an unhedged government bond index is more than 10 years of duration risk. Therefore, currency risk is clearly higher than the interest rate risk of the selected index.
Hedged indices reduce risk
If we look at currency hedged indices as opposed to unhedged indices, the picture changes dramatically and the risk/return profile becomes much more attractive.
Well-diversified indices achieve the highest, risk-adjusted returns.
Data: Annualized quarterly returns for index changes from December 1987 to December 2007. Source: Citigroup.
Range of annual returns, US$ assets from 1987 to 2007 Return %
Risk %
-5
0 5 10 15 20
2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5
WGBI US USD
–4.08%
18.30%
–0.38%
11.67%
Max. rolling annual return
Min. rolling annual return
1–3 yr 1–5 yr 1–10 yr 1–30 yr
Exhibit 2: Full maturity indices may produce wide-ranging returns as illustrated below when this index rose to a high of 18% in the year to December 1995 and a low of -4% in the year to September 1994
Return %
Risk versus Return, Global unhedged versus US$ assets, from 1987 to 2007
1 2 3 4 5 6 7 8 9
1–3 yr
1–5 yr
1–10 yr
1–30 yr
1–3 yr
1–5 yr
1–10 yr 1–30 yr
WGBI US USD WGBI Global Unhedged USD
JPM Cash USD 5.0
5.5 6.0 6.5 7.0 7.5 8.0
Risk %
Exhibit 3: Adding global unhedged indices almost always increases risk
Data: Annualized quarterly returns for index levels from December 1987 to December 2007. Cash Index: JPMorgan Cash Index is based on
12-month LIBOR in USD. Source: JPMorgan and Citigroup.
Exhibit 4 shows that hedged indices are more efficient than unhedged or US$ indices. Currency hedging has removed FX risk, while interest rate diversification has produced better risk-adjusted returns. For example, our analysis shows that it has been possible to receive a com- parable return to the 1- to 5-year U.S. index, by using the less volatile 1- to 5-year global hedged index. In fact, higher returns than those offered by the 1- to 10-year U.S. index can be achieved for a similar level of risk by using the 1- to 30-year global hedged index.
Clearly, currency hedged global indices offer supe- rior risk-adjusted returns compared to single mar- ket indices over the long term.
On a forward looking basis, we believe that hedged indices will continue to provide better risk-adjusted levels of returns though levels of yields may be lower.
Comparison over time
Given 20 years of history, how has the relationship altered over time? Exhibits 5 and 6 tell a consistent story. During both 10 year time periods, the global hedged indices offered better risk-adjusted returns.
Analysis with Euro as the base currency The analysis for currency hedging becomes more com- plex when the base currency is the Euro due to the changes in Europe over the past 20 years. From 1987 to 1997, there was a strong convergence of interest rates with rates falling in those markets that had historically had higher inflation (such as Spain and Italy) and con- vergence towards the lower rates historically prevalent in Germany. This produced an era of strong returns from broad European interest rates that are unlikely to be repeated. Over the last 10 years, interest rate levels have
Return %
Global hedged and unhedged versus US$ indices, 1987–1997
Risk %
WGBI Global Unhedged USD WGBI Global
Hedged USD
JPM Cash USD
WGBI US USD
6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5
1 2 3 4 5 6 7 8 9
Sources: JPMorgan, LehmanLive
Return %Risk versus Return, Global hedged and unhedged versus US$ indices, from 1987 to 2007
Risk %
3 4 5 6
6.5 7.0 7.5 8.0
5.0 6.0
7 8 9
1 2
WGBI US USD WGBI Global Unhedged USD
JPM Cash USD
WGBI Global Hedged USD
6.0
1–3 yr
1–5 yr
1–10 yr 1–30 yr
1–3 yr
1–3 yr 1–5 yr
1–5 yr 1–10 yr
1–30 yr 1–10 yr
1–30 yr
Data: Annualized quarterly returns for index levels from December 1987 to December 2007. Cash Index: JPMorgan Cash Index is based on 12-month LIBOR in USD. Source: JPMorgan and Citigroup.
Exhibit 4: Global hedged indices produce superior returns to unhedged indices at less than half the risk
Currency risk is higher than interest-rate risk
Exhibits 5 and 6: Global hedged indices offer investors better risk-adjusted returns over 10 year periods
Return %
Global hedged and unhedged versus US$ indices, 1997–2007
Risk % 4.5
5.0 5.5 6.0 6.5
0 1 2 3 4 5 6 7 8
WGBI Global Unhedged USD WGBI Global
Hedged USD
JPM Cash USD
WGBI US USD
become more stable but the Euro has fluctuated widely, moving from weakness after its launch in 2002 to con- siderable strength in 2007. These factors can distort the analysis used for U.S. dollar bonds and make the selec- tion of the time period important. However, Exhibits 7–9 suggest that similar conclusions hold true in Europe as in the U.S. — namely currency-hedged indi- ces offer better risk-adjusted returns.
Investment grade credit
Global diversification is also beneficial
Gaining historical perspectives into the credit markets is somewhat limited. First, data is more recent for credit markets than for government bond markets. Second, non-U.S. credit markets have changed rapidly over time and have only recently started to provide the range of issuers and sectors needed to provide broad diversifica- tion benefits.
We have analyzed data from December 31, 1997 to December 31, 2007 to illustrate the benefits of diversi- fication in credit markets (see Exhibit 10 next page).
Exhibit 10 shows that similar conclusions hold true in credit markets as in government bond markets:
1. Unhedged indices add volatility without producing a material increase in returns
2. Global indices hedged to the U.S. dollar reduce risk with a small impact on returns
3. Note that the appearance of higher returns from a U.S. aggregate in this exhibit is primarily due to the greater exposure of the U.S. index to non-government markets. A Global Aggregate Index has a significantly higher percentage weighting of governments: 48%
compared to 24% for the U.S. as of September 30, 2004 and 47% compared to 22% for the U.S. as of December 31, 2007.
Exhibits 7, 8 and 9: Global hedged indices produce superior returns to unhedged indices at close to half the risk
Exhibit 7 Exhibit 8
Data: Annualized quarterly returns for index levels from December 1987 to December 2007. Currency used prior to January 1999 is the Ecu (XEU). Source: Citigroup.
Exhibit 9
Return %
Risk%
Global hedged and unhedged versus Germany indices, 1987–2007
5.0 5.5 6.0 6.5 7.0 7.5 8.0
1 2 3 4 5 6 7 8
1–3 yr 1–5 yr 1–10 yr
1–30 yr 1–3 yr
1–5 yr 1–10 yr
1–10 yr 1–30 yr
1–3 yr 1–5 yr
1–30 yr
WGBI Global Unhedged EUR WGBI Global
Hedged EUR
WGBI Germany EUR
Return %
Risk%
Global hedged and unhedged versus Germany indices, 1987–1997
WGBI Global Unhedged EUR WGBI Global
Hedged EUR
WGBI Germany EUR
1–3 yr1–3 yr
1–5 yr
1–5 yr
1–10 yr
1–10 yr
1–30 yr
1–30 yr
1–3 yr 1–5 yr
1–10 yr 1–30 yr
6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 10.5 11.0 11.5
1 2 3 4 5 6 7 8 9
Data: Annualized quarterly returns for index levels from December 1997 to December 2007. Currency used prior to January 1999 is the Ecu (XEU). Source: Citigroup.
Return %
Risk%
Global hedged and unhedged versus Germany indices, 1997–2007
WGBI Global Unhedged EUR WGBI Global
Hedged EUR
WGBI Germany EUR
2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5
1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5
1–3 yr 1–5 yr
1–10 yr 1–30 yr 1–3 yr
1–5 yr
1–10 yr 1–30 yr 1–3 yr
1–5 yr 1–10 yr
1–30 yr
Data: Annualized quarterly returns for index levels from December 1987 to December 1997. Currency used prior to January 1999 is the Ecu (XEU). Source: Citigroup.
Global hedged indices produce less volatile returns whether measured in U.S.
dollars or Euro
Summary
Our research clearly shows that global unhedged indices produce more volatile returns whether measured in U.S.
dollars or Euro. Global currency hedged indices, how- ever, provide interest rate diversification while remov- ing currency volatility. An analysis of the credit markets also supports this conclusion. Therefore, we recommend that investors use global indices as benchmarks rather than single country benchmarks. Global diversification offers greater return opportunities than single country investments. We also recommend that investors use global indices that are hedged into their base currency.
Hedged strategies have historically provided superior risk-adjusted returns, a trend that we expect to continue.
To ensure that absolute return goals for the portfolio are achieved, consider further diversification options. As cur- rency movements generally have a low correlation with interest rate returns, we recommend that client portfo- lios have some currency exposure. The optimal mix will depend on portfolio objectives with those asset manag- ers most interested in risk-adjusted returns likely to hedge 70% to 90% of their currency exposure in U.S.
dollars. We additionally recommend that asset managers add value to portfolios by using a foreign exchange (FX) overlay strategy relative to their chosen benchmark.
We are happy to share further insights and to answer your questions regarding using global hedge indices as benchmarks for fixed income portfolios. For more infor- mation, please contact your JPMorgan representative.
Return %
Risk %
3 4 5 6 7 8
5.0 5.5
4.5
1 2
7.0
0
Lehman Aggregate Unhedged USD Lehman Aggregate USD
WGBI Global Unhedged USD Lehman Aggregate
Hedged USD
1–3 yr1–5 yr
1–10 yr 1–30 yr
1–3 yr
1–3 yr
1–5 yr
1–5 yr 1–10 yr
1–10 yr 1–30 yr
1–30 yr
WGBI US USD WGBI Global Hedged USD
JPM Cash USD
6.56.0
4.0
