For those investors who follow traditional government bond indexes, the outlook — in particular, relative to the liabilities — is bleak.
According to Bloomberg data, as of March 30, 57 percent of Bank of America Merrill Lynch’s world sovereign bond index yielded less than 1 percent, 38.5 percent yielded less than 0.5 percent, and 24.6 percent had negative yields. In other words, investors who allocate passively in line with this market-capitalized index are guaranteed to lose money on at least one quarter of their investment — even if yields remain unchanged for several quarters.
As central banks have ventured into ever-lower interest rates, forcing bond prices up, high-quality government bonds have actually been a fantastic investment in local currency terms. Central banks have acted defensively in the face of the bouts of economic volatility that have come and gone in the wake of the late-2000s financial crisis. Looking forward, however, current yields — or the lack thereof — suggest that investors need to think about alternative approaches to this traditional defensive asset class.
So how can one navigate this extraordinary situation to generate attractive returns over the coming years? The vast majority of investors take their cues from some form of market-capitalized government bond benchmark. They do so because it makes performance measurement easy, helping to define an investment style and to construct a portfolio objectively. It is our belief at Investec Asset Management, however, that these advantages are outweighed by disadvantages.
First, the more a government borrows, the greater its representation in the index. This aspect could prove misleading; a country with a conservative fiscal policy may have attractive yields but little or no representation in the index. Second, the index will have its longest duration at the bottom of the interest rate cycle, threatening future returns as yields rise. Third, a market-cap index rewards those markets with the most expensive currencies. Fourth, such indexes fail to recognize how the world is changing by ignoring fast-growing countries that have little outstanding debt.
Given that 47.6 percent of the BofA Merrill Lynch world sovereign bond index is comprised of countries that have imposed negative interest rates, investors really need to consider alternatives if they are to construct a portfolio that generates positive returns that keep pace with the cost of their liabilities.
As soon as nominal interest rates hit zero in many economies, investors searched for yield in lower-quality assets, such as corporate bonds or emerging-markets debt. Unfortunately, their returns were undermined dramatically when the U.S. dollar rallied sharply, commodity prices fell, and the value of emerging-markets currencies collapsed. Investors with liabilities in stronger currencies were hit particularly hard. As has been the case in the past, therefore, the search for yield proved that there are no easy investment options.
Negative rates are here to stay for the foreseeable future. For an investor from a country that has taken this route and can only hold domestic-currency-denominated assets, the only way to boost returns is to radically shift the asset allocation from bonds into equities. Investors who can allocate to other currencies, however, can generate attractive returns in the bond markets. They can take advantage of the fact that shorter-dated government bonds have greater variability of returns than those with longer maturities. They can also capitalize upon new opportunities, widening their investment universe by seeking beyond the majors, or boost returns by hedging currency exposure.
Financial globalization and corresponding freer movement of capital have led to yields correlating across global markets. A principal component analysis determines that one factor has dominated much of the movement in global ten-year bond yields, and its influence has increased in recent years. We believe this factor is a world interest rate — one that drives all other government bond returns. This rate can be thought of as a simple average of U.S., German and Japanese yields. On a currency-hedged basis, therefore, it makes little difference if an investor buys Korean or Polish government bonds; the returns will be dominated by the world interest rate.
For shorter-dated bonds, however, returns are more dispersed, as domestic monetary policy imposes a greater influence than is possible at longer maturities. Greater dispersion of returns should mean more opportunities for active investors to add value.
Russell Silberston is head of multiasset absolute return at Investec Asset Management in London.
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