The Benefits of an Active Approach to Global Fixed Income March 2020
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Insight Paper The Benefits of an Active Approach to Global Fixed Income march 2020 Key Takeaways ◼ The global fixed income universe provides significant opportunities for discerning investors to generate returns and diversify their portfolios. ◼ A passive global index-tracking approach exposes investors to meaningful and unnecessary interest rate and currency risk, especially in today's low-yield environment. ◼ A flexible, active approach provides greater opportunity for managers to invest in more attractively priced segments of the market, mitigate risk, and generate alpha. ◼ Dodge & Cox offers a differentiated approach to global fixed income, featuring a total return mindset, a focus on credit, and a long-term investment horizon. The $100 trillion global bond universe offers active investors the United Kingdom has access to approximately one-tenth a large and diverse investment opportunity set. Experienced of the number of issuers relative to a global bond investor. and skilled managers with a flexible approach are well In addition, domestic bond strategies typically only have positioned to find inefficiencies by looking across credit, exposure to home-market interest rates and no currency currency, and rates markets to identify issuers with the most exposure, while global strategies typically include exposure attractive risk-reward profiles. Variations in interest rates and to a wide array of interest rates and currencies. While all asset economic cycles across countries create a fertile ground allocation decisions must be guided by the specific risk and for country and security selection and offer meaningful return objectives of the investor, we believe global bonds are diversification benefits. a good complement to a domestic bond strategy and can Investing solely in one’s home bond market restricts provide compelling risk and return benefits. access to this wider range of opportunities. An investor in Passive Investing Entails Heightened Risks Figure 2: Low Yields, Low Returns: Starting Yields and Taking a passive, benchmark-driven approach, or focusing Subsequent Five-Year Returns Across the Globe on minimising index tracking error, imposes significant risks Returns Measured in Local Currency because global bond indices have inherent flaws in our view. United StatesUnited Bonds Statesd Bonds Low/Negative Interest Rates 14% For passive global bond funds, interest rate exposures are 12% determined by how much debt is outstanding and the maturity ← Current Yield 10% of the underlying bonds. This means the largest interest rate 8% exposures are to the largest and most indebted countries. 6% Year Year Return Today, these countries face common challenges: slow growth, - 5 4% worsening demographics, and low and even negative yields. 2% At the same time, as government and corporate issuers have Return 5-Year Subsequent 0% taken advantage of the low-yield environment by issuing 0% 2% 4% 6% 8% 10% more long-dated bonds, the durationa, or interest rate risk, Yield to Worst Source: Bloomberg Index Services. embedded in the benchmarks has increased significantly. Furthermore, the low yield levels shown in Figure 1 may United Kingdom Bondsd not compensate the investor sufficiently for the heightened United Kingdom Bonds interest rate risk. 16% 14% ← Current Yield Figure 1: Global Benchmarkb Yields Are at Lows, 12% While Interest Rate Risk Is at Highs 10% 7.5 12% 8% Duration (LHS) 7.0 Year Return 6% 10% - Yield (RHS) 5 4% 6.5 8% 2% Subsequent 5-Year Return 5-Year Subsequent 6.0 0% 6% Yield 0% 2% 4% 6% 8% 10% 12% 5.5 Yield to Worst Duration (years) 4% 5.0 Source: Bloomberg Index Services. 4.5 2% 4.0 0% Japanese Bondsef 1990 1994 1998 2002 2006 2010 2014 2018 Japanese Bonds Source: Bloomberg Index Services. 14% 12% For example, Japanese Government Bonds represent ← Current Yield 16%c of the Bloomberg Barclays Global Aggregate Bond Index 10% 8% (Bloomberg Barclays Global Agg). Over two-thirds of those 6% are more than five years in duration. The average nominal Year Return - 5 4% and real (inflation-adjusted) yields on these bonds are 0.02% Subsequent 5-Year Return 5-Year Subsequent 2% and -1.00%, respectively, assuming long-term inflation of 0% approximately 1%. These yield levels make long-term return -1% 1% 3% 5% 7% 9% prospects challenging. Yield to Worst Figure 2 plots historical starting yield levels against the Source: Bloomberg Index Services, JPMorgan. five-year subsequent return for bond indexes across the four major developed market currencies, and highlights the Euro Area BondsEurodg Area Bonds strong relationship between the two. Given current yield 8% levels (highlighted in orange), intermediate-term return 7% ← Current Yield expectations should be low. 6% Furthermore, global bond benchmarks’ large allocations 5% to developed market government bonds come at the expense 4% Year Year Return 3% of allocations to more interesting and attractively priced areas - 5 2% of the market. For example, credit markets and emerging local 1% Subsequent 5-Year Return 5-Year Subsequent markets comprise relatively small portions of the benchmarks, 0% but offer significant excess return opportunities to active 0% 1% 2% 3% 4% 5% 6% investors who are willing and able to research fundamental Yield to Worst Source: Bloomberg Index Services. outlook and value within these markets. 2 Global Bonds and Currency Risk advantaged relative to investors who are limited to their home Unhedged global bond indices have large, passive exposures market or benchmark-driven strategies. Even in a low-yield to currencies (e.g., over 50% of the Bloomberg Barclays environment, skilled managers using an investment approach Global Agg is non-U.S. dollar) whose large swings in value that is flexible, selective, and focused on the long term can overwhelm any returns being generated by the underlying can construct a diversified portfolio with compelling total bonds. return prospects. We see value in focusing on areas of the An analysis of historical data suggests that hedged market that offer significant differentiation and where we can benchmark returns provide superior risk-adjusted returns benefit from market inefficiencies, such as corporate bonds, to unhedged benchmark returns. Figures 3 and 4 show emerging market local debt, and structured products (e.g., comparisons of volatility and Sharpe ratioh (a measure of mortgage-backed, asset-backed securities). Credit, rates, risk-adjusted returns) for home market bond benchmarks and currency exposures should be carefully selected and versus global hedged and unhedged benchmarks. These rigorously managed. figures illustrate that, of the three benchmarks, over the long run, global hedged benchmarks have produced the lowest 1) Managed, Active Credit Approach volatility and the highest Sharpe ratios, an indication of While credit is a small part of bond benchmarks, it is a stronger risk-adjusted returns. Global unhedged benchmarks big source of opportunity for active investors. Yet many have provided low risk-adjusted returns. global bond managers focus primarily on top-down portfolio These statistics create a compelling case that passive construction and emphasise rate and currency views. Credit currency exposure is not attractive because it adds volatility, securities offer incremental income relative to government regardless of an expectation for positive returns. However, bonds and, when selected carefully and held over the long term, an analysis of this data alone overlooks the opportunities this income compounds and generates a durable source of for active currency management. An active and disciplined returns. For example, since 1990, the Bloomberg Barclays U.S. approach to currency management offers numerous ways Corporate Bond Index (investment-grade corporate bonds) to enhance and diversify the long-term return prospects of a has produced positive excess returns (i.e., returns higher global bond portfolio. than duration-matched U.S. Treasuries) in over 70% of rolling three-year periods. Levers of Active Global Bond Investing Active investors with expertise in credit have many Investors who take an active approach to finding opportunities other tools to add value. The Bloomberg Barclays Global across the vast and diverse global universe are significantly Agg contains over 2,100 credit issuers, which provides Figure 3: Bond Market Volatility by Base Currency, Annualizedfi Figure 4: Bond Market Sharpe Ratios by Base Currency, Annualizedfi JanuaryJanuary 1991 1991 to to December December 2019 2019 JanuaryJanuary 1991 1991 to to December 2019 2019 Home Market 4.2% Home Market 0.77 Global: FX-Hedged 2.7% EUR Global: FX-Hedged 0.83 Global: Unhedged 6.6% EUR Global: Unhedged 0.39 Home Market 5.5% Home Market 0.61 Global: FX-Hedged 3.1% GBP Global: FX-Hedged 0.96 GBP Global: Unhedged 8.4% Global: Unhedged 0.36 Home Market 4.0% Home Market 0.78 Base CurrencyBase Global: FX-Hedged 3.0% Global: FX-Hedged 0.96 JPY JPY Global: Unhedged 8.4% Global: Unhedged 0.49 Home Market 3.5% Home Market 0.79 Global: FX-Hedged 3.0% Global: FX-HedgedComplete transparency and accuracy in disclosures 1.00 USD USD Global: Unhedged 5.3% Global: Unhedged 0.48 0.0% 5.0% 10.0% 0.00 0.20 0.40 0.60 0.80 1.00 1.20 Source: Bloomberg Index Services, JPMorgan. Source: Bloomberg Index Services, JPMorgan. Note: EUR bond returns start in February 1999. Note: EUR bond data starts in February 1999. EUR = euro. GBP = British pound. JPY = Japanese yen. USD = U.S. dollar. THE BENEFITS OF AN ACTIVE APPROACH TO GLOBAL FIXED INCOME 3 significant scope for bottom-up research and issuer selection. evolve and globalise. Overall, we believe credit plays a vital Managers with an experienced credit research and trading role in a global bond portfolio. team and emphasis on intensive fundamental analysis can isolate opportunities from within this wide selection. Careful 2) Emerging Market Local Bond Opportunities research of each investment mitigates default risk and can Emerging market local bond markets have grown rapidly in provide the conviction needed to maintain holdings through the last few decades, but are still underrepresented in global periods of market stress.