Most Popular ArticlesThe Global Bond Market: Opportunity or Opportunity Cost
Loomis Sayles
David W. Rolley
February 25, 2010
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In 2010, fixed-income investors may face a tough hurdle if they constrain their investment universe by focusing solely on US bond market investments. In order to help meet their objectives of generating income while preserving capital, investors may need to diversify away from the US dollar and US Treasurys in a careful and judicious way. The US Investment Environment
In the US, investors are confronted by the government’s massive budget deficits, which represent an unprecedented financing challenge that could drive US government bond yields significantly higher. The US Treasury has announced it will issue $1.5 to $2.0 trillion dollars in new US Treasurys in 2010. The US federal fiscal deficit is expected to exceed $1 trillion dollars in 2010 and 2011, according to forecasts from the US Congressional Budget Office (CBO). The US Office of Management and Budget (OMB) estimates that US debt as a percent of GDP will increase from 50% to approximately 100% of GDP over the next decade, as shown in the chart below.
The fiscal challenge the government faces, potentially exacerbated by policy gridlock, could contribute to an exceptionally unpredictable outlook for US dollar assets. At this juncture, policymakers are presented with a double dilemma. If nothing is done legislatively to reduce the deficit, inflation risk could escalate. However, extreme spending cuts to bring the deficit in line could create serious economic growth challenges. The unpredictability of these scenarios could contribute to an adverse environment for US-dollar assets.
This outlook has many US investors rethinking the potential opportunity costs of their home-country bias. More and more, it appears institutional investors are seeking portfolio managers for global fixed income mandates in lieu of US-only directives. Institutions cite the expansive opportunity set and diversification characteristics that the global bond market affords. Expanding the Opportunity Set& Gaining Diversification
The global bond market is a multi-faceted investment universe that can vastly broaden the opportunity set for active managers. Sixty percent of the world’s bond supply is located outside of the United States, as shown in the chart on the following page. The breadth of the global fixed income investable universe is compelling. At the end of 2009 the $35 trillion market value of the Barclays Capital Global Aggregate Bond Index was more than twice as large as the Barclays Capital US Aggregate Bond Index. The Global Aggregate Index included in excess of 12,000 issuers from more than 50 different countries.
The influence of exchange rates on correlations can be seen in the table below, which covers a significant multi-year currency cycle. The leadership of the US in the global technology boom of the late 1990’s attracted capital into the US dollar driving up its valuation. With the subsequent burst in the technology bubble in 2000, the US dollar lost its relative appeal with global investors. The economic recession that began in 2001 weighed on dollar demand, as did relatively low US interest rates when the country was emerging from recession. In contrast to the economic picture in the US, positive developments in emerging markets prompted significant capital flows to some of these countries from 2004 through 2007. A flight to quality in 2008 contributed to a sizable rally in the dollar that ended up withering in 2009 as yield spreads narrowed during a recovery in asset valuations. Reflecting on performance for the 2000 – 2009 period, many returns of non-US-dollar assets were driven by a generally weak US dollar.
Correlations Suggest favorable Diversification Opportunities
The table below displays the relatively low correlation between international bonds as represented by the Barclays Capital Global Aggregate EX-US Index) versus major asset classes for the 10-year period ending December 2009. The international bond index had a correlation coefficient of 60 when compared to the US Government Credit Index. In addition, when compared to equities, global bonds and international bond indices had low correlations with the S&P 500 Index as well as the MSCI EAFE Index.
Table 2 below shows the Correlations of Real Government Bond Yields and illustrates one factor that contributes to the overall low correlation among countries’ performance. For the 10 countries listed, the highest correlation in real yields was between Taiwan and Germany. While the lowest correlation, a negative relationship, was between Mexico and the US.
DIFFERENTIATION IN 2010
The broad market sell-off during the financial crisis in 2008, followed by the “risk on” trade in 2009, contributed to increased correlations between countries in general. However, as investors increasingly differentiate between investment opportunities based on fundamentals and reasonable projections, these correlations are not likely to be sustainable and could break down. We believe active managers with a global mandate should be well positioned to take advantage of the resulting inefficiencies that are likely to emerge.
Global Opportunity in 2010—Our View
If there is an investment theme for the year ahead, it is that it will be a bond-picker’s market, where gains are likely to be made in small increments from tactical moves into a variety of global bonds and currencies. The challenge for investors will be to create a portfolio with a diversified set of return drivers. These should include non-dollar fundamental exposure, global corporate bonds where there is an opportunity to add value relative to governments, and exposure to markets where there may be a value perception. More specifically, a focus on issue selection within emerging markets in both the private and public sectors should provide a performance advantage. Since the US-dollar-versus-euro trade is unlikely to benefit performance, investors could potentially do better extending beyond benchmark currencies.
Stepping back and assessing growth, we believe that Asian corporate bonds and currencies can offer attractive opportunities because of the prospect for yield and foreign exchange capital gains. Favorable economic data and strong country fundamentals should support higher valuations. While China is the engine of growth in the region, overvaluations in that market limit the potential upside of securities there. Even with restrained bank lending, China should continue to drive growth in the region.
Other emerging-markets countries that may offer favorable prospects include Brazil and Mexico. Brazil is a key counterparty to China and a natural resources superpower. While the economic prospects of Mexico are tied to the US recovery, its debt offers higher yields while the peso appears undervalued. Even though Mexico faces massive private and public sector management challenges, it could benefit from its solid federal treasury and central bank. In addition, the country should benefit from an increase in capital inflows and a nascent recovery in tourism and remittances from ex-pat workers in the US.
Looking at currencies, solid macroeconomic fundamentals in Norway contribute to the Norwegian krone’s appeal. The Swedish krona is also attractive; the country is leveraged to growth with the highest density of multinationals per capita. Conclusion
In 2010 the US bond market is unlikely to offer investors the yield or capital appreciation opportunities they may require to meet their investment objectives. Instead, investors will need to expand their investment universe and employ deft security and currency selection in the global bond market. In that expanded opportunity set, investments in non-US, high-quality governments and supranationals could offer capital preservation, while emerging-markets debt and corporate debt might present performance prospects. In the non-dollar securities arena, investors could take advantage of securities offering capital preservation as well as performance.
Benchmark Definitions
Indexes are unmanaged, do not incur fees and it is not possible to invest directly in an index.
Barclays Capital Global Aggregate Bond Index covers the most liquid portion of the global investment grade fixed-rate bond market, including government, credit and collateralized securities. The liquidity constraint for all securities in the Index is $300 million. Barclays Capital US Aggregate Index covers the USD-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The Index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS sectors. The US Aggregate Index is a component of the US Universal Index in its entirety. Barclays Capital US Government/Credit Bond Index includes Treasurys (public obligations of the US Treasury that have remaining maturities of more than one year) and agencies (publicly issued debt of US government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the US government) as well as other publicly issued investment grade corporate and foreign debentures that meet specified maturity, liquidity, and quality requirements. Barclays Capital US Corporate High Yield Bond Index covers the universe of fixed rate, non-investment grade debt. Pay-in-kind bonds, Eurobonds, and debt issues from countries designated as emerging markets (e.g. Argentina, Brazil, Venezuela, etc.) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-emerging market countries are included. Original issue zeroes, step-up coupon structures and 144As are also included. JPMorgan Emerging Markets Bond Indices Plus (EMBI+) tracks total returns for external-currency-denominated debt instruments of the emerging markets: Brady bonds, loans, Eurobonds, and US denominated external debt instruments. MSCI EAFEIndex (Europe, Australasia, Far East) is a free float-adjusted market-capitalization Index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. S&P500 Index is a capitalization-weighted Index of 500 stocks. The Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The Index was developed with a base level of 10 for the 1941-43 period. Diversification does not ensure a profit or guarantee against a loss. Past performance is no guarantee of future results. This material is provided by Loomis Sayles for informational purposes only and should not be construed as investment advice. Investment decisions should consider the individual circumstances of the particular investor. Any economic projections or forecasts contained herein reflect the subjective judgments and assumptions of the authors and actual results will be different. There can be no assurance that developments will transpire as forecasted. Accuracy of data is not guaranteed but represents our best judgment and can be derived from a variety of sources. Loomis, Sayles & Company, L.P., One Financial Center, Boston, MA 02111 www.loomissayles.com. MALR006064 (c) Loomis Sayles
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