International Bond Portfolios Research Articles

Currency hedging and quantitative easing: Evidence from global bond markets

AbstractWe examine the influence of quantitative easing (QE) in the United States on hedging effectiveness and performance (E&P) of international bond portfolios. During the QE period, the bond portfolios have significantly lower excess returns and variances, and their excess returns (variances) are positive (negative) with the U.S. Federal Reserve's (Fed's) mortgage‐backed securities holdings and are less positive (less negative) with the Fed's Treasury holdings. E&P is higher for optimal versus full hedging during the QE versus pre‐QE period and differs for portfolios from developed and emerging countries. Results are robust using other hedging E&P measures and excluding countries with their own QEs implementations.

Currency Hedging of International Bond Portfolios: Effects of Unconventional Monetary Policy Regimes

We examine the influence of Quantitative Easing (QE) on hedging effectiveness and performance (E&P) of international bond portfolios. During the QE period, the bond portfolios have significantly lower excess returns and variances, and their excess return and variance sensitivities are positive and negative with the Fed's MBS holdings and are less positive and less negative with the Fed's Treasury holdings. E&P are higher for optimal versus full hedging during the QE versus pre-QE period and differ for portfolios from developed and emerging countries. Results are robust using other hedging E&P measures and excluding countries with their own QEs.

On the theory of international currency portfolios

The paper develops a general equilibrium theory of the optimal currency composition of international bond portfolios. Like the partial equilibrium portfolio balance literature of the 1980s, the theory emphasizes the critical roles of government debt and government balance sheet operations in the determination of portfolios, prices and allocations. Consistent with empirical findings, optimal foreign currency positions are found to be small, with their size decreasing with exchange rate volatility, while optimal domestic currency positions are large and increasing with domestic interest rates. A large open market purchase of domestic currency bonds from private households lowers domestic interest rates.

US investment in global bonds: as the Fed pushes, some EMEs pull

We analyse reallocations within the international bond portfolios of US investors. The most striking empirical observation is a steady increase in US investors’ allocations towards emerging market local currency bonds, unabated by the global financial crisis and accelerating in the post-crisis period. Part of the increase in emerging market economy (EME) allocations is associated with global ‘push’ factors such as low US long-term interest rates and unconventional monetary policy as well as subdued risk aversion/expected volatility. But also evident is investor differentiation among EMEs, with the largest reallocations going to those EMEs with strong macroeconomic fundamentals such as less volatile inflation and more positive current account balances.

Sovereign risk and its changing effects on bond duration during financial crisis

We examined the effects of sovereign risk on bond duration in European and Latin American sovereign bond markets over the period 1996 to 2011. We compared the sovereign risk-adjusted duration with the Macaulay duration for both investment- and speculative-grade US dollar-denominated sovereign bonds. We found that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all ratings, and the ‘shortening’ effect is stronger for lower rated bonds, which generally intensified during the recent financial crisis. Results are robust when credit default swap (CDS) prices are used as a proxy for changes in sovereign risk. This study provides evidence for advocating the importance of adjusting the bond duration for sovereign risk. More important, this study provides a practical methodology for estimating a sovereign risk-adjusted duration measure for managing international bond portfolios.

Putting the “C” into crisis: Contagion, correlations and copulas on EMU bond markets

We investigate the contagion appetite generated by the current debt crisis in Greece by focusing on six European Monetary Union bond markets, namely the Netherlands, Germany, Italy, Spain, Portugal and France. We use a framework that contains two procedures, a spillover regime/switching model and a time-varying copula model. The empirical evidence confirms contagion appetite to European Monetary Union countries, which are prone to contagion, some because of their excessive macroeconomic imbalances and others because of the sovereign's risk perception and the arbitrage appetites of international bond portfolios; but not an overall contagion effect from the crisis country to all others.

Putting the 'C' to Crisis: Contagion, Correlations and Copulas on EMU Bond Markets

We investigate the contagion appetite generated by the current debt crisis in Greece by focusing on six European Monetary Union bond markets, namely the Netherlands, Germany, Italy, Spain, Portugal and France. We use a framework that contains two procedures, a spillover regime/switching model and a time-varying copula model. The empirical evidence confirms contagion appetite to European Monetary Union countries, which are prone to contagion, some because of their excessive macroeconomic imbalances and others because of the sovereign's risk perception and the arbitrage appetites of international bond portfolios; but not an overall contagion effect from the crisis country to all others.

Global Asset Pricing: Is There a Role for Long-Run Consumption Risk?

We estimate long-run consumption-based asset pricing models using a comprehensive set of international test assets, including broad equity market portfolios, international value/growth portfolios, and international bond portfolios. We find that differences in returns across assets within a country are sometimes (and most prominently for the U.S.) better captured by the assets' exposure to long-run consumption risk as opposed to their exposure to one-period changes in consumption (the canonical consumption CAPM). Across countries, however, exposure to long-run consumption risk does not provide a better fit than the canonical consumption CAPM. Thus, when characterizing the cross-country distribution of returns, long-run consumption risk does not seem to play any particular role, even if long-run risk is important for explaining the cross section of expected returns in the U.S. Furthermore, we show that consumption growth is more predictable over short to medium-run horizons than over longer horizons and that empirical evidence of a declining risk aversion parameter estimate in long-run risk models has to be interpreted with care.

Currency Investing in Global Portfolios: Hedging or Speculative Benefits?

This paper investigates whether and how currency strategies can enhance the performance of international bond and equity portfolios. Currency positions may deliver hedging benefits, pure investment, i.e. speculative benefits, or both simultaneously. We develop a new test that decomposes the total change in Sharpe ratio resulting from adding currency positions to any risky portfolio, into the share due to hedging and the share due to speculative benefits of currencies. This allows us to identify, measure and compare economically and statistically these two sources of value added. Based on stock and bond returns from 12 developed countries between 1975 and 2007, we find that adding currency deposits to international equity or bond portfolios significantly enhances their performance, leading to a doubling of their Sharpe ratios. Our decomposition shows that, while economically non-negligible, the hedging benefits of currency positions are not statistically significant. Most of the performance enhancement delivered by currency positions can be attributed to their speculative benefits, which are both economically large and highly statistically significant. These results are robust for various static and dynamic investment strategies and for investors with different home currencies.

Total Return and Credit Spread Diversification in International Bond Portfolios

In this study we investigate the factors responsible for diversification in international corporate bond portfolios. We observe that interest rate factors are the most important single cause of diversification of total portfolio returns. Maturity diversification follows as the second most effective risk reduction strategy, while credit rating and seniority diversification effects are unimportant. Interest rate and maturity diversification are also found to be the dominant strategies to reduce the volatility of credit spreads. Finally, contrary to recent evidence from the stock market, industry diversification produces but a negligible impact on the volatility of corporate bond portfolios.

Global Bond Portfolios and EMU

We examine the bilateral composition of international bond portfolios for the euro area and the individual EMU member countries. We find considerable support for euro area bias: EMU member countries disproportionately invest in one another relative to other country pairs. Another striking pattern is the positive connection between trade linkages and financial linkages in explaining asymmetries across EMU member countries in terms of their outward bond investments vis-a-vis external counterparties. Our empirical results underline the impact of currency union on financial integration and support the notion that financial regionalization is the leading force underlying financial globalization.

Diversification, Original Sin, and International Bond Portfolios

This paper has two main goals: to analyze country allocations in international bond portfolios and to describe the development of bond markets around the world. In the primary analysis, we find that country weights in U.S. investors' foreign bond portfolios are determined by the openness of capital accounts and potential diversification benefits. Positions in local-currency-denominated bonds are particularly sensitive to past and prospective volatility of returns. Analysis of reallocations in bond portfolios from 1997 to 2001 reveals a flight to quality from countries with low and declining credit ratings; reallocations in U.S. investors' equity portfolios also reveal a discriminating flight from higher credit risks. In the secondary analysis, we present measures of the size and currency composition of bond markets and analyze the development of local currency bond markets. We find that while country size and the level of economic development influence the level of bond market development, past policies---as evidenced in the level and volatility of historical inflation---play an important role. An implication for developing countries is that creditor friendly policies, such as vigilance on the inflation front, can enable local bond market development and in turn attract global investors, in part by promoting the development of derivative instruments that allow the decoupling of bond and currency investments.

Diversification, Original Sin, and International Bond Portfolios

While there is a severe home bias in U.S. investors' foreign bond portfolios, we find that portfolio weights are greater for countries with more open capital accounts and whose bond returns are less correlated with U.S. returns. Positions in local-currency-denominated bonds are particularly sensitive to past and prospective returns volatility. An analysis of changes in portfolio weights over time indicates that U.S. investors have recently moved out of smaller markets and those with low and declining credit ratings. Our data also allow for an analysis of the size and currency composition of international bond markets. We find that countries with stronger institutions and better inflation performance have larger local currency bond markets. An implication for developing countries is that creditor friendly policies, such as vigilance on the inflation front and the development of strong institutions, can enable local bond market development and may in turn attract global investors.

Common Factors in International Bond Returns

In this paper we estimate and interpret the factors that jointly determine bond returns of different maturities in the US, Germany and Japan. We analyze both currency-hedged as well as unhedged bond returns. For currency-hedged bond returns, we find that five factors explain 96.5% of the variation of bond returns. These factors can be associated with changes in the level and steepness of the term structures in (some of) these countries. In particular, it turns out that changes in the level of the term structures are correlated across countries, while changes in the steepness of the term structures are country-specific. We find similar results for bond returns that are not hedged for currency risk. We show how the model can be used to calculate duration-type risk measures and Value at Risks for international bond portfolios, and compare the results with simpler models. Finally, we demonstrate how cross-currency interest rate derivatives can be priced with the model.

The Merits of Active Currency Risk Management: Evidence from International Bond Portfolios

(1993). The Merits of Active Currency Risk Management: Evidence from International Bond Portfolios. Financial Analysts Journal: Vol. 49, No. 5, pp. 63-70.

Immunizing bond portfolios in a multiple term structure economy

This paper develops a new immunization model in a multiple term structure economy. Multiple term structures would exist, for example, in international bond portfolios whose constituent securities differ with respect to default probabilities and/or liquidity. With multiple term structures, we show that the immunized planning horizon is not at the point of portfolio duration, but at a new point defined through future value duration.