UK investors considering whether to allocate to global investment-grade credit may discover the broader diversification benefits can significantly improve a portfolio’s overall risk dynamics.
4 minute read
UK investors have traditionally allocated to gilts and other sterling-denominated investment-grade bonds for the “safer” fixed income part of their portfolios, choosing to get direct exposure to other currencies through their equity and alternative allocations. In terms of geographies, around 50 per cent of the sterling market is comprised of global companies such as Unilever and Procter & Gamble, indirectly adding exposure to other economies.1
Yet, while the sterling investment-grade market is robust, broadening an allocation further – to global investment-grade credit – can deliver significant diversification benefits. Global investment-grade bonds achieve lower volatility for similar levels of excess returns or spreads, even accounting for the hedging costs associated with mitigating currency risk.
A world of possibilities
At A-, the global investment-grade segment’s average credit rating is just one notch below sterling’s (A), while offering a market capitalisation approximately 13 times larger – and more than four times the number of issuers, with much greater diversification across sectors. For instance, banking accounts for over a quarter of the sterling index.
Figure 1: Size of the global and sterling investment-grade markets
Figure 2: The global investment-grade market is more diverse
Shorter duration, lower volatility
In terms of portfolios’ risk budgets, global investment-grade credit is also attractive because its duration is a year shorter than the sterling index – at 6.82 years and 7.9 years respectively.2
This means that, while sterling spreads are typically wider than their global counterparts, when adjusted for duration the difference is small. This modest spread differential is also largely explained by the fact the large, predominantly US dollar-denominated, global investment-grade market is much more liquid than its sterling equivalent.
Figure 3: Comparing global and sterling option-adjusted spreads across credit ratings
The reward for bearing credit risk is therefore comparable on both markets, with spreads of global allocations exhibiting lower volatility over five and ten years, giving investors a smoother journey (see Figure 4). The volatilities shown below are not adjusted for duration, but the duration-adjusted volatility of the sterling investment-grade index is also higher than that of the global index.
Figure 4: Volatility of spreads over five and ten years
Global investment-grade credit delivers a further diversification benefit because it is naturally tilted to a variety of currencies – mainly US dollars, but also Australian dollars and Japanese yen among others. By systematically hedging currency exposures back to the base currency, global investment-grade funds benefit from this diversification but without trying to guess which way currencies will move.
Indeed, foreign-exchange markets are so volatile that trying to second guess their direction to generate alpha is fraught with risk. Instead, when portfolios are hedged back to the base currency, portfolio managers remain free to focus on adding value through the quality of their credit selection.