Below Zero: International Bond Investing Gets Harder
August 14, 2012
- Investors looking for diversification in international bond investments face as challenging an environment as we've ever seen. Global debt markets are increasingly split between low-to-negative-yielding bonds in countries perceived to be safe and very high yields in countries perceived to be risky. Meanwhile, the US dollar has rallied against other major currencies, reducing returns from bond investments denominated in foreign currencies.
- We believe international diversification remains important for bond investors because it has historically provided a way to help reduce overall volatility in a portfolio. However, investing in bonds with negative yields increases potential for negative returns and raising volatility.
- Although international index funds generally provide broad exposure to various international bond markets, rapidly changing perceptions about the riskiness of various countries may mean that investors are gaining exposure to markets they'd rather avoid. Moreover, some of the indexes are less diversified by country now than in the past.
- Given current market challenges, many investors may be better off using actively managed funds or professional managers to help diversify their bond portfolios rather than passive funds, in our view. Balancing currency, credit quality and interest-rate risks is difficult.
Paying a high price for "safety"
Negative bond yields are becoming more common in global debt markets. Yields on the government debt of countries like Germany, Finland, Switzerland and Denmark have moved into negative territory recently, reflecting investor concern about the debt crisis in the eurozone. The European Central Bank (ECB) recently lowered its base lending rate to zero due to the region's recession and banking problems. Six of the 17 eurozone countries are in recession and several others have gross domestic product growth rates below 1%. Europe's banking sector is under stress from an overhang of bad debt in some countries and lending has declined, reducing liquidity and further straining the economy.
Negative yields indicate that some investors are willing to pay for safekeeping of their money. They're simply more focused on return of their money than the return on it. This may be especially true for investors in bonds issued by Germany and Finland, because both countries retain AAA ratings, while credit ratings for several other eurozone countries have fallen.
In addition, for some investors the decision to buy negative-yielding bonds is driven more by expectations about the currency's performance than the interest rate. Negative yields in Denmark and Switzerland, to some extent, may reflect expectations for currency strength—especially relative to the euro. However, investors must be aware that investing in negative-yielding foreign bonds may mean negative returns. The return on the bond will depend almost entirely on the currency performance, which means there's potential for sharply positive or negative returns and high volatility.
Two-year Bond Yields Turning Negative
Source: Bloomberg, daily data as of July 26, 2012.
Meanwhile, negative bond yields in parts of Europe contrast sharply with higher yields in more-troubled European economies, such as Spain and Italy. These divergences within the eurozone recently sent the yield differentials between German bonds compared to those of Spain and Italy to the widest levels since the euro was formed, causing ECB officials to consider intervention in the markets.
Spanish and Italian Two-Year Bond Spreads Widening to German Bunds
Source: Bloomberg, daily data as of July 26, 2012.
Outside of Europe, the divergence between "safe" and "risky" markets has increased as well. US and Japanese bond yields continue to reach new lows, despite rising government debt levels in both countries. Bond purchases by central banks are holding rates down, but both countries also have large and liquid financial markets, and long histories of repaying debt on time—factors that have historically supported bond markets. While these factors don't ensure against future losses, investors appear to be showing more confidence in the United States and Japan than in many other countries.
The stronger dollar has also contributed to problems for US-based investors in foreign bonds. Over the past year, the dollar has risen by about 10% against other major currencies on a trade-weighted basis and about 15% against the euro. For investors buying bonds or bond funds that don't hedge currency exposure, the advance in the dollar has offset returns generated from income and capital appreciation on foreign bonds.
Consequently, for US-based investors, investments in non-USD developed-market bonds have produced the unhappy combination of way-below-average returns with the characteristically high volatility associated with taking currency risk. The Barclays Global Aggregate ex-US Index posted a return of -0.33% for the 12 months ending June 30 compared to a gain of 6.2% for the same index where the currency exposure was hedged. Investors who chose to invest in hedged bond funds had better outcomes and investors who stayed with domestic US bonds had even better returns. However, when we look at returns over five- and 10-year periods, hedging currency exposure has produced lower returns, albeit with lower volatility.
Source: Schwab Center for Financial Research, with data from Morningstar, Inc. Annualized average and standard deviations calculated from monthly total returns for periods ending June 30, 2012. Indexes cannot be invested in directly. Return figures do not take into account expenses. Past performance is not indicative of future results.
Diversification: Taking the long-term view
Despite the current challenges, we still believe that investors benefit over the long run from international bond diversification. Over the past 20 years, returns from developed market non-USD bonds have had a low correlation with US stocks. In other words, the movement of the two asset classes has not been closely related, which helps reduce the volatility in a portfolio.
Over the past year, however, the correlation between US stocks and foreign bonds has been significantly higher than it had been historically. As the table below illustrates, the correlation coefficient for the S&P 500 index and the unhedged Barclays Global Aggregate ex-US Index at 0.53 is about three times higher than the 20-year correlation of 0.17. (Correlation coefficients range from -1.0 to 1.0. A reading of 1.0 indicates perfect correlation while a reading of -1.0 means the two indexes would be perfectly negatively correlated.) The abrupt shift in correlations may be one reason why many investors with diversified portfolios have experienced much more volatility in the past year than they might have anticipated.
Correlation of Stock and Bond Returns
Source: Schwab Center for Financial Research with data from Morningstar, Inc. Correlations are between monthly total returns from January 1, 1991 through June 29, 2012. Indexes cannot be invested in directly. Return figures do not take into account expenses. Past performance is not indicative of future results.
In contrast, the hedged portfolio of foreign bonds actually showed a negative correlation with the S&P 500 index—a very unusual event. So investors who chose to avoid currency risk not only saw better returns but also lower volatility. Much of this reflects the tendency for investors to flock to the safety of the US dollar, in our view.
Ideally, when constructing a portfolio it helps to have assets that demonstrate low or no correlation, or that are even negatively correlated. By holding assets that don't tend to move together, a portfolio should be less volatile. Although we may be in a period of high volatility and unusually high correlations between stocks and foreign bonds denominated in foreign currencies, over the long run, there have been diversification benefits derived from holding non-US bonds in a portfolio to balance the risk of domestic and foreign stocks.
Ultimately, the decision to take currency risk or not comes down to having a view of the US dollar's outlook against major currencies. The dollar has been rising over the past year, but the trend of the past 10 and 20 years has been one of weakening. The most diversification comes from taking some currency risk, but there are benefits even with a hedged portfolio of foreign bonds.
Active versus passive
Navigating shifting trends in the global debt markets has never been easy, but it's even more challenging now in light of negative yields and unusual correlation patterns between markets. For many investors, it may make sense to look for professional management or an international bond fund to help with the process. A fund manager backed with a research team may be able to stay on top of the changing economic and political landscape and avoid some potential pitfalls an individual investor may face.
Moreover, following a broad international bond index may not produce the level of diversification most investors are seeking. Bond indexes tend to reflect the size of the market, so countries with the most debt are often the most heavily weighted in the index. For example, the Barclays Global Aggregate ex-US Index is heavily weighted toward bonds denominated in Japanese yen and euros, with less than a third invested in bonds of other regions.
2012 Country Composition
Source: Barclays, Global Aggregate ex-US Index, as of July 6, 2012. Market value in $ billions.
Additionally, due to changes in bond-issuance patterns by some countries, the index now has a relatively long duration (longer-maturity bonds) than it had just a few years ago, exposing investors to a portfolio concentrated by country and currency with increased interest-rate risk. Typically, investors looking for international diversification are trying to avoid concentrated portfolios.
Global Bond Index Duration Trend
Source: Barclays, Global Aggregate ex-USD Index using the market structure report of unhedged data, as of July 6, 2012.
We still believe in the long-term diversification benefits of investing in non-US bonds. In our view, it's unlikely that the recent trend of heightened correlation between non-US bonds and stocks will continue or that negative yields will persist over the long run. For most investors however, this unusual and volatile investing environment may warrant seeking professional management of foreign bond investments.
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International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks.
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Diversification strategies do not assure a profit and do not protect against losses in declining markets.
The Barclays Global Aggregate Index ex-US provides a broad-based measure of the global investment-grade fixed-rate debt markets. The two major components of this index are the Pan-European Aggregate and the Asian-Pacific Aggregate Indexes.
Barclays US Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed and mortgage-backed securities with maturities of one year or more.
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