- Strategies that emphasize the bonds of countries with strong debt-servicing economic resources, rather than the bonds of countries with the highest debt issuance, have the potential to outperform.
- High-yield index strategies, which mirror factor investing in equities, especially the intersection of quality and value, offer investors the opportunity to outperform traditional high-yield indices.
- In today’s low-yield environment, investors with fixed income mandates can improve performance with strategies designed to pick up incremental returns from mean reversion and that limit overexposure to both lower-quality creditors and large issuers.
As investors, we are constantly in the uncomfortable position of having to plan for the future with limited guidance from the past. Our job byline may as well be “uncomfortably stuck between past and future.” As a striking example, the relentless global march toward lower bond yields over the last 40 years is rather unlikely to persist in the decades to come. As zero to negative interest rates take hold around the world, many of the principles we use to navigate capital markets become increasingly less valuable (Brightman, 2016). The concept of a risk-free return, as a result, is teetering on the edge of relevance these days—quaintly unhelpful at best, wealth-destroying at worst.
Investors whose mandates include fixed-income allocations face some difficult decisions. Strategies designed to pick up incremental returns from mean reversion and that limit overexposure to both lower-quality creditors and large issuers have the potential to deliver a welcome edge in performance to both government and high-yield bond investors.
Bonds in Current Time
Although government bonds may provide investors near certainty of notional capital being returned, the risk of locking in long-term losses can also be a near certainty with negative real rates and the prospect of interest rates inevitably trending higher. Equating risk and volatility may be too simplistic to deal with the world we face today. In markets for government debt, favoring the a priori safe bet of high-debt-issuer countries, such as the United States, Japan, and developed European nations, can be far riskier to an investor’s wealth than interest-rate volatility or credit ratings may suggest. And although volatility can be an investor’s friend in credit markets, especially in high-yield corporates, by creating opportunities to trade against short-term mispricings, not all risk-taking is rewarded equally.
Improving Government Bond Portfolio Returns
A simple, yet robust, framework for forming reasonable long-term expectations is offered in the Research Affiliates expected returns methodology, publicly available on our website. As of October 31, 2016, our methodology suggests that global (ex-US) Treasury markets, measured by the Barclays Global (ex-US) Treasury Index, are expected to return between ?1.9% and 2.3% over the next decade, with a central tendency of 0.2%, after inflation. The fact that the central tendency is positive is largely the result of expected currency movements. A weakening of the US dollar relative to global currencies is expected to add 1.3%, but no help is offered from the current real yield of ?0.4% and the ?1.1% expected return from current high valuations.
For many investors, an allocation to government bonds is the starting point for portfolio construction. When that allocation is expected to return nearly nothing over the next 10 years, the task of constructing a satisfactory portfolio is just that much more challenging. That said, a likely path for improving long-term potential returns in global government bonds is to be thoughtful and disciplined in allocating to country exposures.
Bond markets are built on the premise that issuers can borrow against the future, and some countries seem to be borrowing from a future far less rosy than thorny. With both high starting debt burdens and demographic trends associated with significant off-balance-sheet future borrowings combined with a reduced ability to spur growth, advanced economies such as Japan and the United States face major impediments to managing their ballooning national debt burden in the future. Yet, the debt of these countries dominates government allocations in traditional bond indices as a mechanical byproduct of their dominance in cumulative notional issuance.
Over the last few years, investors have been rewarded for their substantial exposure to these countries. A combination of bond-buying programs by central banks, negative- and zero-interest-rate policies, and continued fears that a new global crisis may be around the corner (a hard path to Brexit being the latest source of such concern) have held the pedal down on the flight to safety. Perhaps conditions will remain in place for investors to benefit from these allocations, but the possibility for retrenchment can also be convincingly argued: bond markets allow creditors to borrow against the future, and eventually the future tends to conform to harsh (but logical) economic realities, not feel-good hopes and fictions.1
Investment professionals are familiar with the saying “don’t fight the Fed.” While this may aptly apply to traders, long-term investors can be less heedful of this admonition. Those with long-term investment horizons can benefit by gaining exposure to bond strategies that allocate to countries on the basis of debt-servicing economic resources rather than debt issuance, effectively raising the relative credit quality of holdings. Gaining exposure to the less popular, less prolific issuers, not widely viewed as safe harbors in a volatile world, also allows long-term investors to capitalize on market inefficiencies.
Investors who position their portfolios to benefit from the reassertion of long-term economic realities may not find it comfortable or profitable in the short term. For instance, in the year ending September 30, 2016, the Citi RAFI Sovereign Developed Market Bond Index, an index that anchors on fundamental measures of a country’s size relative to the world economy, underperformed an issuance-weighted index by approximately 1.5%. The underperformance was driven by a substantial underweight to Japanese debt just when the country was experiencing an extraordinary bond rally engineered by the Bank of Japan’s quantitative easing program.2 The average weight to Japan in the fundamentally weighted index was roughly 9% versus 30% in the cap-weighted index over the 12-month period.
We would not expect the recent underperformance to continue indefinitely, but neither can we predict when the tide will turn in favor of fundamentally weighted developed sovereign bond indices.3 Investors, for example, who have taken the position that Japan’s interest rates will imminently reverse (after a protracted 20 years or more hovering at zero or just above) have entered into a trade notoriously known as “the widow maker.” Our preference would be to protect our families from such a fate.
In global government bond markets today, investors seem to be standing atop tectonic plates, which are moving slowly yet predictably, defying simple rules of thumb about risk-free investing, and rendering the last 40 years of historical data a very poor guide for making decisions about the future. In the current vacuum of relevant historical experience, investors who choose a strategy that follows a rules-based methodology which emphasizes debt-service capacity, capitalizes on observable inefficiencies, and implements at low cost, should be well-positioned to weather the era-defining changes likely ahead.
Improving High-Yield Bond Portfolio Returns
Investors in corporate credit, especially high-yield bonds, tend to face shorter cycles of booms and busts than do government bond investors, and therefore have more frequent opportunities, as a result of year-over-year price volatility, to advantageously position their portfolios. High-yield bonds are an equity-like asset class, whose