Global bonds: Four key drivers of outperformance

Investors with fixed income portfolios can diversify and improve yields by choosing products that supplement core bond holdings with international bonds.

Even better, these benefits can be achieved while buying similarly rated bonds and without adding duration risk.

Vanguard’s global active fixed income team positions itself to take advantage of the $140 trillion global marketplace every day. Allocating to global bonds provides potential diversification benefits through exposure to additional inflation risk factors, economic environments, and market cycles, as well as market, sector, and credit risk premiums.¹

U.S. investors pay more for bonds from familiar companies, while they tend to expect a higher premium (spread) from unfamiliar names.² This dynamic often results in European companies facing higher spreads when issuing bonds in U.S. dollars (USD); similarly, U.S. companies issuing bonds in euros pay a premium, despite equally strong credit profiles.

• For example, as the graphs below show, bonds issued in euros for Honeywell, American Tower, and J.P. Morgan all offer higher spreads over government bonds versus the bonds from the same issuers in USD. This, in turn, can result in higher yields when these foreign currency bonds are hedged back to USD.

Changing geopolitical environments, regulatory frameworks, demographics, and monetary and fiscal policies further exacerbate performance disparities between bonds issued in different countries. Among corporate bonds, sector- and company-level factors can also produce premia. 

• Bonds issued by companies with improving credit profiles and attractive valuations tend to perform best and present an opportunity for active managers. For example, regional banks in Europe are experiencing an upgrade cycle, while U.S. regional banks are challenged by the slide in commercial real estate.

• Southwest in the U.S. and easyJet in Europe are both regional airlines rated BBB by S&P. Yet, easyJet bonds trade with a higher spread, providing another example of the benefits of going global to pick up income without changing the quality of the investment. 

Regulations in different regions can drive financial innovation. Global markets have developed new types of corporate bonds, and the markets for these instruments tend to be deeper and more liquid outside the U.S. Choosing the right part of the capital structure can help deliver better results.

• European banking regulations offer exposure to different parts of the capital structure, such as senior non-preferred bonds, which sit in the middle of bank financing seniority. Hence, they tend to offer higher yields for the same underlying credit risk.

• For example, bonds issued by BNP Paribas, a large French investment bank, include senior non-preferred. Those rank behind senior preferred bonds and above subordinated debt in the credit system. European utilities also have subordinated debt in the form of hybrids that offer higher yields.

Currency hedges can protect portfolio returns from foreign currency volatility and stabilize yields across countries. While differences may vary by country, small gains in a larger portfolio can add up significantly.

• For example, a one-year Japanese government bond that yields 0.2% in Japanese yen would yield the equivalent of 4.7% when hedged to USD, 0.2% more than a 1-year Treasury bond.³

Active managers can leverage these and other factors and adjust based on changing market conditions. Has the currency exchange rate changed? Perhaps the premium for ex-U.S. bonds is lower than Vanguard believes to be fair value, so managers may decide to wait to buy a particular bond or set of bonds.

Spread-widening because of country-specific concerns may present an opportunity for better risk compensation, prompting a potential buy. Our expert teams around the world are well positioned to find the best prospects for our funds.

The market is always changing. It is our job as active managers to ferret out what we believe are the best choices. We believe that successful active management over time is not about leveraging large macro bets, but consistently finding value, sometimes in small differences, so investors who can benefit from exposure to global bonds can fully leverage those opportunities. 

• Active Fixed Income Perspectives Q3 2024: The high road (article, issued July 2024)
• Our active fixed income approach (video, issued April 2024)
• Active fixed income and our ownership structure (article, issued February 2024)