Global bonds are loans made to foreign governments and companies in return for interest. Pension funds may be tempted to invest in global bonds after their table-topping performance last year – the Investment Management Association’s (IMA) Global Bonds sector index, for example, generated an impressive 16 per cent return in 2008. Compare this with losses of 10 per cent and 32 per cent respectively for Sterling Corporate Bonds and UK All Companies indices, and the global bonds sector seems irresistible.

The health of that global bonds sector depends on a number of specific factors such as the prevailing economic and political conditions from country to country, investor sentiment and – for global bond funds – fund manager ability. A short-term period of good fortune is hardly reason for pension funds to pile in. The backbone of the IMA Global Bonds sector is sovereign debt (ie government bonds). As a result the significant falls many high-yield corporate bonds (which refer to bonds with companies that are considered to have a greater chance of defaulting) suffered last year are not factored in.

Nevertheless, global bond funds can be a useful addition to a pension portfolio. As part of a long-term investment strategy they bring diversification – reducing the fund’s reliance on UK equities and bonds – and allow exposure to varying economic conditions around the world. “Global bonds offer returns more closely matched to pension scheme liabilities than other forms of investment,” says Graham Wardle, director at independent trustee company BESTrustees. “They are definitely an area pension funds should consider as long as the risks are understood.”

WHY INVEST NOW?

Just as the UK government issues bonds known as Gilts, so other governments around the world issue their own equivalents. For example, the US government issues bonds known as Treasury Bonds or T-bills, and the German government issues Bunds. Collectively, these are known as sovereign bonds. And just as UK companies issue bonds to raise capital (corporate bonds), so do foreign companies. Global bonds come in a variety of maturities and credit qualities, and most are denominated in the currency of their home country.

At first glance it may seem sensible to concentrate on sovereign bonds, which tend to do well when the economy is in bad shape and investors are at their most risk averse. Compared to the serious losses many corporate bonds (particularly non-investment grade, or high-yield, bonds) have suffered, average returns for sovereign bonds have been very good over the past year and have played a significant role in pushing the global bond sector to the heights described at the beginning of this article.

“The primary drivers for investing in sovereign bonds were interest rate cuts in all the world’s major economies, and mounting anxiety that the global recession will be deeper than originally expected,” says Guy Skinner, fund manager of the SWIP (Scottish Widows Investment Partnership) Global Bond Plus Fund.

Indeed, when interest rates are so low and investor sentiment is wounded, there is usually a flight to investing in government bonds. They are seen as a safer bet than other asset classes but with a better return than cash. However, yields (money received purely for holding the bond) on government bonds are low and not sufficient to match pension scheme liabilities. In this light, most analysts agree that for pension funds currently considering a move into global bonds, corporate bonds may make more sense.

Corporate bond prices tend to move in the same direction as equities because they share a common factor, which is the health of the underlying companies. In the current economic climate, then, investors worry that global companies may run into financial difficulty, causing their bonds to default. As a result, many corporate bond prices are floundering at low levels because panic-stricken investors have fled the scene – a perfect bargain hunting opportunity.

“Capital values (the total value of a bond) in global corporate bonds have depreciated, which makes them an attractive investment to buy into now,” says Wardle of BESTrustees. “Many pension funds bought into global corporate bonds before they crashed and are sitting on losses, but if they hold bonds as part of a long-term strategy there should be no reason to get out of them now.” In other words, they can sit back, enjoy the high yields and wait for a recovery.

Bond yields rise when prices fall, so high yields are a consequence of exaggerated expectations that many bonds will default. Should the defaults not occur markets would have falsely priced in an over-reaction, which makes high-yield corporate bonds excellent value at present, with the potential for equity like returns when prices recover.

WHAT ARE THE RISKS?

We have been talking about the good value that high-yield corporate bonds currently represent. However, although investor nervousness about the fragility of corporate bonds may have been overdone to some extent, defaults and downgrades worldwide are on the up given the current recession, and this represents added risk. Some corporate bonds are high yield for a reason – the company may be running out of cash.

Moreover, certain governments – often emerging market governments – have flimsy corporate governance in place compared to others, which puts their companies at greater risk of defaulting. A spread of bonds should mitigate this risk, but pension funds still need to select their global bonds with care.

Even sovereign bonds represent a risk factor. In the UK we think of government bonds (Gilts) as risk-free, but historically many foreign governments have defaulted on their sovereign bonds or devalued their currency due to political factors.

“Say a country deliberately devalues its currency for competitive reasons – to make exports cheaper, for example – and you have not hedged your currency risk,” says April LaRusse, fixed income product specialist at Insight Investment. “Your investment is going to be worth less to you as the value of your assets is corroded.” Exchange rate risk is another factor. As with domestic bonds, global bond prices rise and fall in line with interest rate movements.

But they also rise and fall if there are changes to the exchange rate of a bond’s denominated currency. Just look at the positive performance of sovereign bonds for UK investors over the past year – this can be directly linked to sterling’s fall against other currencies.

Some global bond funds hedge against currency risks by taking positions on foreign exchange markets or using futures contracts. There is no space to explain how these strategies work, but for global bond funds they remove the worry that exchange rate fluctuations will reduce the value of their holdings. Other global bond funds choose not to use hedges because they want to get exposure to foreign currencies in the hope it will add to their returns.

“At the moment you want the currency risk because sterling is depreciating,” says LaRusse. “You need a clever asset manager to decide when you want to take those currency risks and when you don’t.”