• The magnitude of drawdowns in fixed income in 2022 might have alarmed some bond investors.
• But drawdowns in global fixed income markets should not distract investors from the crucial role that bonds can play as a volatility dampener in their portfolios.
• Thanks to their shock-absorbing properties, we believe that hedged global bonds will remain an integral and enduring building block in multi-asset portfolios over the long term.

 

Like many other asset classes, currency-hedged global bonds sold off in 2022¹ as spiking global inflation and the aggressive monetary policy tightening response by central banks weighed on broad investment-grade fixed income and equity markets alike.

For some fixed income investors, the magnitude of the drawdowns in fixed income last year might have appeared alarming. Maximum drawdowns in hedged global bonds in 2022 rivalled those seen in other asset classes which are traditionally considered riskier and more volatile than bonds². But drawdowns in global fixed income markets should not distract investors from the crucial role that bonds can play as a volatility dampener in their portfolios.

The unravelling of duration risk

As major central banks instigated exceptional monetary stimulus measures in the wake of the global financial crisis, this helped to drive down both short- and long-dated bond yields to historic lows, benefitting returns in investment-grade fixed income markets and riskier asset classes.

Sovereign and corporate debt issuers took advantage by locking in low rates and extending principle repayment through ultra-long bond issues, and investors in turn sought yield increasingly further out on the risk and maturity spectra. As a result, duration risk—the sensitivity of a bond’s price to changes in interest rates accounting for characteristics of the bond such as yield, coupon rate and maturity—steadily built up, as the chart shows.

Duration risk steadily built up – then rapidly unravelled

Source: Bloomberg, Vanguard. Broad EUR bond market represented by the Bloomberg Euro Aggregate Index. Data from 31 December 1996 to 28 February 2023.

Then, in 2022, this duration risk unravelled as global monetary conditions abruptly reversed and central banks ended bond purchasing programmes and raised policy rates. This caused yields across fixed income sub-asset classes to rise. For investors, this led to magnified losses in bond markets on a scale normally associated with equities, with double-digit maximum drawdown percentages for most investment-grade fixed income categories—global bonds inclusive—as well as in most other major asset classes.

One important point to bear in mind here is that, with duration risk now significantly lower (and policy rates substantially higher) than investors have experienced for several years, the risk of similarly large drawdowns in global bonds is reduced³.

But fixating on bond drawdowns in isolation also risks diverting investors’ attention from one of the core reasons why many of them invest in fixed income in the first place. In reality, investors typically own bonds alongside other asset classes in portfolios, and most of them therefore prize the shock-absorbing qualities of fixed income – rather than holding bonds purely as a performance proposition.

Viewed through this lens, we believe that volatility—as measured by annualised standard deviation—is a more relevant measure of the recurrent risks facing long-term investors in global bonds than maximum drawdown, which is more associated with tail risk, or the risk of low-probability events.

Using volatility as a yardstick, hedged global bonds were one of the best tools in helping investors weather the turbulent markets of 2022 and act as a shock absorber relative to other asset classes in multi-asset portfolios. The table below shows the volatility and maximum drawdown of a range of asset classes in 2022.

2022 was a year of risks for many asset classes

Asset class	Volatility	Maximum drawdown
Commodities	26.41%	-17.30%
Global equities	15.75%	-16.68%
Global aggregate bonds (unhedged)	7.91%	-11.25%
Global aggregate bonds (hedged)	5.77%	-15.13%

Source: Bloomberg, Vanguard. Data from 31 December 2021 to 30 December 2022. Volatility represented by standard deviation, annualised. Annualisation is based on weekly total returns. Benchmarks used as proxies: Commodities - Bloomberg Commodity Index Total Return; global equities - MSCI ACWI Net Total Return Index; global aggregate fixed income - Bloomberg Global-Aggregate Total Return Index; global aggregate fixed income hedged to EUR - Bloomberg Global-Aggregate Total Return Index Hedged EUR.

When assessed according to volatility, there are few viable alternatives to hedged global bonds as a diversified portfolio building block to reduce portfolio risk, in our view.

In addition to providing investors cost-effective access to a diversified universe of nearly 30,000 underlying bonds⁴, global hedged bonds had one of the lowest levels of volatility among major asset classes in 2022 during what was generally a volatile year in for financial markets.

In 2022, hedged global bonds had a volatility of 5.77%, which compares favourably to the volatility profile of global equity markets (15.75%), which many investors are looking to hedge with global bonds. Elsewhere, broad commodity exposures⁵ had a volatility of 26.41%.

One reason that global bonds were able to offer investors relatively low volatility in an otherwise turbulent market environment was down to the global diversification between local bond markets as individual central banks responded differently to inflation and growth expectations in their respective markets as 2022 unfolded.

The importance of hedging global bonds

Overlaying a currency hedge to foreign-currency bonds also helped to dampen the volatility of global bond portfolios - an important feature given the relative high volatility of currencies, especially those which are highly correlated with the bond market in that country.

Compared with unhedged global bonds, hedged global bonds’ volatility of 5.77% was lower than the 7.91% volatility of the unhedged equivalent, underscoring the shock-absorbing effect of hedging bond exposures to an investor’s local currency.

Exchange-rate volatility can amplify the volatility of overseas bond exposures when translated into an investor’s home currency. For example, if a particular foreign currency depreciates relative to an investor’s home currency at the same time that bond prices in that foreign market fall, the decline translated into the investor’s home currency will be larger. Currency hedging overseas bond exposures back into the domestic currency can help bond investors to reduce volatility while maintaining returns.

After a tough 2022, we expect that fixed income investors are set for a brighter 2023. And over the long term—thanks to their risk-dampening properties—hedged global bonds will remain an integral and enduring building block in multi-asset portfolios.

 

¹ Source: Bloomberg, 31 December 2021 to 30 December 2022. Global aggregate fixed income hedged to EUR, as represented by the Bloomberg Global-Aggregate Total Return Index Hedged EUR, returned -13.27% from 31 December 2021 to 30 December 2022.

² Source: Bloomberg, 31 December 2021 to 30 December 2022. From 31 December 2021 to 30 December 2022, the maximum drawdowns in Global aggregate fixed income hedged to EUR (as represented by the Bloomberg Global-Aggregate Total Return Index Hedged EUR), commodities (as represented by the Bloomberg Commodity Index Total Return) and global equities (as represented by the MSCI ACWI Net Total Return Index) were -15.13%, -17.30% and -16.68% respectively.

³ Source: Vanguard.

⁴ Source: Bloomberg as at 20 March 2023. The Bloomberg Global Aggregate Float Adjusted and Scaled Index in EUR had 29,211 constituents as at 28 February 2023.

⁵ Source: Bloomberg, 31 December 2021 to 30 December 2022. Benchmarks used as proxies: Commodities - Bloomberg Commodity Index Total Return; global equities - MSCI ACWI Net Total Return Index; global aggregate fixed income hedged to EUR - Bloomberg Global-Aggregate Total Return Index Hedged EUR.