(PUB) Investing 2016

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Currency Is Key in World-Bond Funds Income Strategist | Karin Anderson

result, carry the most currency risk among the three subgroups examined here. From a regional standpoint, half the group focuses on non-U.S. debt while the rest have a global purview. More than half of these of- ferings focus mostly, if not solely, on government debt. A smaller subset focuses on global or non-U.S. corporates, and just a few are dedicated to global inflation-linked bonds. Therefore, funds in this cohort sport varying levels of interest-rate and credit risk. sures back to the U.S. dollar. These funds focus on Treasuries or a mix of Treasuries and corporates, and there are no dedicated high-yield or inflation- protection strategies in the group. Here investors forgo currency risk, with hedged versions of the Barclays Global Aggregate and the Barclays Global Aggregate ex-U.S. serving as common benchmarks. Our Top Picks Unhedged world-bond funds are the most volatile of the three category subgroups, largely because of currency movements, so investors need a higher risk tolerance. PIMCO Foreign Bond Unhedged PFBDX has experienced nearly twice the volatility (as measured by standard deviation) as its hedged sibling over the past decade through December 2015 . Given that tactical funds court at least some currency risk and many, including Templeton Global Bond TPINX and Loomis Sayles Global Bond LSGLX , have large helpings of emerging-markets debt, it follows that the tactical group has been closer to the unhedged cohort in experiencing higher levels of standard deviation and steeper sell-offs in downdrafts. By contrast, hedged world-bond funds including PIMCO Foreign Bond USD-Hedged PFODX and Vanguard Total International Bond Index VTIBX have standard deviations more akin to those of the Barclays U.S. Aggregate and other U.S. government debt indexes. Investors looking to diversify equity risk should consider this subgroup as it has displayed lower correlations to the S & P 500 over time. K Contact Karin Anderson at karin.anderson@morningstar.com Hedged: The smallest subset ( 17% of world-bond funds) comprises funds that fully hedge currency expo-

Solid long-term performance and diversification from U.S. bond and equity markets have made the world-bond fund Morningstar Category one of the fastest-growing categories that Morningstar tracks. Because of the wide variety of approaches (un- hedged versus U.S. dollar-hedged, global versus non- U.S., broad-based versus single-sector), funds within the category have a large range of risk exposures. It makes most sense to divvy up the category by various approaches to currency management rather than by credit, regional, or sector focus, as currency move- ments have the most significant impact on risk/ return profiles. World-bond funds tend to follow one of three currency management approaches: unhedged, tactically hedged, and U.S. dollar-hedged. Tactical: Nearly 60% of world-bond funds employ a tactical approach to currency hedging as of December 2015 . The managers of these funds actively manage exposure to non-U.S.-dollar currencies through currency forwards or futures. Some of these funds’ managers will make modest adjustments to these exposures relative to an index, while others rely more heavily on currency to add returns. In the latter case, managers will often hold net short positions to individual currencies or will have a positive view on a currency but not own any underlying bonds. Most in this subgroup are focused on a combi- nation of government and corporate debt, with the Barclays Global Aggregate appearing as the most common benchmark. The government-only Citi World Government Bond Index is also prevalent. More than two thirds of these funds have a global purview; the remaining funds exclude the United States. Unhedged: Around one fourth of active and passive world-bond category funds leave their overseas currency exposures completely unhedged and, as a