A Better Bond Blueprint? by John Taylor, AllianceBernstein
Bond strategies based on benchmark indices have big limitations and could expose investors to an unattractive mix of investment risks. Is there a better blueprint for global bond investors?
“Going global” in fixed income should enable investors to dramatically expand their opportunity sets. And adding more markets and issuers to portfolios should secure valuable diversification benefits.
But tracking the core global bond benchmark index, the Barclays Global Aggregate Bond Index (or Agg), could leave investors both under-diversified and overexposed to US interest rates. The Agg has grown more sensitive to interest rates as bond yields have plummeted and the world awaits a liftoff in US rates. In our view, the index isn’t yielding enough to compensate investors for the greater interest-rate risks they’re taking.
In addition, the current make-up of the Agg raises big questions about whether it provides dependable diversification from equity-market volatility.
How to Go Global?
As a market-weighted index, the Agg reflects bond issuance levels—a poor guide to intrinsic value. Tracking the Agg guarantees a portfolio that’s about 40% concentrated in a combination of US Treasuries, US mortgage-backed securities and Japanese government bonds (JGBs).
JGBs are a good example of the potential pitfalls posed by some big index constituents. The Bank of Japan’s quantitative easing (QE) bond-buying program has driven JGB yields down so far that they’re now some of the lowest in the world. This suggests they’re very poorly placed to offset the impact of a potential Japanese “taper tantrum” when the Bank of Japan eventually brings QE to a close.
Choosing bonds on the basis of which countries and companies issue the most tradeable debt won’t open up the full diversity of the global opportunity set. Bonds issued by Brazil, Russia, India and China combined, for example, account for less than 1% of the Agg, compared with Japan at more than 14%.
Is there a smarter way to pick global bonds than approximating their position sizes in the Agg?
Dangers of Some Alternative Approaches
One alternative approach is to base weights on countries’ economic output. But this too has flaws.
A country’s weight would increase in such a benchmark when its economy is growing faster than its counterparts. Most often, a strengthening economy will coincide with tighter monetary policy aimed at preventing economic overheating. So when this index methodology is signaling that a country’s weighting should be increased, the country’s bond prices may be just about to decline.
Furthermore, a GDP-weighted approach to global government bonds can also lead to meaningful skews and biases. Currently, a GDP-weighted approach would bring significant allocation to Russian sovereign debt and tiny weightings in New Zealand and Irish government bonds. The former is a risky proposition given the big challenges facing the Russian economy, while the latter offer an attractive combination of solid yields and high quality credit metrics.
Breaking Free of Benchmarks
Given these strikes against rigid methodologies, investors are increasingly building portfolios with more flexibility to emphasize pockets of value and tone down outsized or poorly compensated risks.
“Go anywhere” portfolios can make use of the full global bond playing field. And by pressing as many different return-seeking, risk-reducing and diversification levers as possible, they can aim to perform in lots of market conditions.
The two biggest return levers in bond portfolios are credit and interest-rate (duration) calls. These two levers thrive in different market conditions. Credit performs best in “risk on” environments and duration in “risk off” ones.
Portfolios that use these two levers flexibly may improve their chances of weathering changing market circumstances. There are times when higher-yielding bonds with lower credit ratings than the safest government debt—and with closer correlations to equity markets—will offer most value.
And to secure effective ballast against equity-market volatility, a portfolio needs to increase its interest-rate exposure, as the longest-duration bonds tend to hold up best when equity markets pull back.
That said, some of the yields on big Agg constituents like JGBs are now so low that they have very little room to fall any further. As a result, they can’t provide a meaningful cushion when equity markets slide. By contrast, Australian government bonds (which make up well under 1% of the Agg) enjoy sufficiently generous yields to ensure they can act as good safe havens when appetite for risk sours.
This suggests that ditching benchmark baggage and focusing on best global bond ideas regardless of their weightings in bond indices could prove a more rewarding blueprint.
We believe that tapping into the full diversification potential of the global bond universe may help portfolios preserve more capital when bonds come under pressure—and better mitigate risks when equity markets feel the heat.
This article originally appeared in Investment Europe.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.