If investors had forecasted large-scale quantitative easing and negative interest rates a decade ago, they would have been met with incredulity. Now, however, the truly unconventional has become mainstream. Unfortunately, return expectations have not yet assimilated this new reality, and most models still embed a reversion to the historical mean. Although the U.S. has begun the slow task of normalizing monetary policy, most policymakers in other developed-markets economies continue to have a bias toward loosening. It is now difficult to imagine monetary policy reverting to where it was before 2008. How are bond investors to build resilient portfolios in such a challenging world?
International investors can generate higher returns on bond portfolios in times of negative interest rates by considering a widening of their investment horizons beyond major markets. At Investec Asset Management, we believe this approach does not necessarily mean that investors have to take on more risk, but simply that they need to think differently about risks to which they are exposed.
Because we want government bonds in a given portfolio to behave defensively and perform well against declining expectations of economic growth, we take a cautious approach to credit, focusing on markets that have a foreign currency long-term credit rating of A– (or equivalent) and higher. In contrast, we have observed that securities with ratings below this threshold act more like growth assets, and therefore their performance is positively correlated to market sentiment.
It is also important to have reasonable liquidity. For us, this means avoiding countries that have in excess of $50 billion in outstanding debt.
And there are other considerations to ensure that bonds generate genuinely resilient returns. These include looking for stable, low-volatility markets, as measured by the normalized three-month yield variation; a large, liquid market, as indicated by a maximum total outstanding debt; a high level of issuance with less than five-year maturity; and efficient markets with low dealing costs, as measured by bid-offer spreads and estimated daily volume.
If we accept that there is more variability of returns in shorter-dated bonds, then a resilient portfolio, which provides returns that are consistent regardless of the market environment, could provide a passive approach to long-dated duration by simply including liquid Treasuries, German Bunds and Japanese government bonds. To deliver absolute positive returns, the manager of a resilient portfolio can take advantage of market inefficiencies in the one- to five-year segment. In such a scenario, the investor needs to outwit the market at forecasting interest rates. Fortunately, the market — and indeed policymakers — is particularly bad at this, and there are always opportunities to add value across a wide array of economies.
Although there is no escaping negative yields for domestic bond investors who cannot invest in overseas assets, for international investors, hedged returns in those countries can be attractive. The yield achieved by hedging the currency risk can become a significant component of total return. Since January 2014, one- to three-year Swiss government bonds denominated in Swiss francs have returned 0.74 percent in local terms but 2.77 percent in U.S. dollar terms. Yields were already negative at the start of this period and were –71 basis points as of the end of 2015. By contrast, one- to three-year Treasuries have returned 1.89 percent over the same period in dollar terms. Why has this happened?
By buying foreign government bonds, an investor implicitly takes a long position in the foreign currency in which they are denominated. It is possible for investors to hedge this exposure through forward foreign exchange contracts, however. In this widely used mechanism, two parties agree to exchange a set amount of one currency for another at an agreed-upon exchange rate in the future. To avoid risk-free returns, a relationship known as covered interest rate parity must hold. If the foreign market’s interest rate is higher than that of the domestic market, the forward price of the foreign market’s currency will be lower than its spot price to reflect the higher interest rate earned, thereby removing the possible riskless return. Consequently, yields on foreign bonds move closer to an investor’s domestic market return.
By hedging the currency risk in this way, hedging yield becomes a significant component of total return that must be considered when international investors determine expected total return and assess performance. In the topsy-turvy world of negative interest rates, and despite U.S. interest rates hovering near zero, hedging costs relative to Swiss francs are positive and therefore earn a U.S.-based investor a significant pickup over domestic interest rates.
In Investec’s most recent post, we noted that for those investors who follow traditional government bond indexes, the outlook — particularly relative to their liabilities — is bleak. Finding alternative sources of yield isn’t easy, but by considering small countries, taking active interest rate risk and thinking about hedged returns, investors can still earn positive absolute returns from high-quality government bonds.
Russell Silberston is head of multiasset absolute return at Investec Asset Management in London.
Get more on fixed income.
