From the December 2011 issue of Investment Advisor • Subscribe!

November 28, 2011

Use Global Fixed Income to Improve Diversification

The increasingly complex fixed income market is a result of a more deeply intertwined global landscape

Today, there are more opportunities for individual and institutional investors alike, allowing them to gain access to the global fixed income universe. Investors have the ability to invest in global strategies which may include allocations to specific countries or the combination of multiple regions.

It is said without hesitation that investing within the fixed income arena today is much more complicated than it was over a decade ago. For example, interest rate swaps and cross currency swaps have become common terms and are utilized across most strategies. Rewind the clock just five years and the landscape has changed tremendously. The argument can be made that fixed income investing is always changing and evolving. A primary force behind the change is that global market interdependence has increased. U.S. investors are not only challenged with analyzing and fully understanding the intricacies of a single market and the impact of the central bank’s actions on the broader market. Today, a strong understanding of the central banks of our global neighbors and the interaction between all parties is needed. This is evident with the ongoing European sovereign debt crisis and the way government policy not only effects local markets, but markets abroad.

Investing within the global fixed income markets adds elements to your portfolio which may over time help your overall returns. Adding a global component to your strategy will help provide greater diversification, which is crucial to a portfolio. The introduction of diversification is a concept everyone is aware of when referring to your broad asset type mix. It is one way to help mitigate risk and reduce volatility. Since 2000, there has been a global trend to diversify away from U.S. dollar currency reserves. This trend is highlighted by the currency composition of foreign exchange reserves (COFER) computed by the IMF. This shows that there is a steady decline in the U.S. dollar as a proportion of total foreign exchange holdings from 50% in 2000 to 34% in 2010. Simply put, less demand for USD reserves places downward pressure on USD-denominated debt, which could benefit foreign bond markets.

Global diversification also helps reduce systemic risk as business cycles are not globally uniform in nature. One way to measure this is to analyze the correlation of the monthly total returns between the Barclays Capital U.S. Aggregate Index and the Barclays Capital Global Aggregate Ex-USD Index. The result shows that since November 2000, these indexes carry a 56% correlation. With increasing globalization, both in capital markets and goods markets, correlations between international markets have increased modestly. Diversification should also be utilized within the fixed income portion of your portfolio and needs to be measured not only at the security level, but also sector level and through the geographic region. Ultimately, diversification can’t eliminate risk, just reduce it.

Global markets today are more intertwined than ever. With the United States accounting for roughly 30% of the world’s productive capacity (measure by GDP), it makes sense to increase diversification and take advantage of the global markets. Relative value opportunities arise almost daily,  created by varying global economic and interest rate cycles. Today’s investor has the advantage of being able to position his or her portfolio to take advantage of these opportunities in order to boost long-run returns.

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