Why You Can Do Better Than Domestic Bonds
By: John Makowske
History has shown that good global bond managers will outperform domestic managers by a large margin. John Makowske, of Rogge Global Partners, explains why.
Actively managed global bonds will outperform Canadian bonds, or for that matter, any country’s domestic bond market over the medium and long-term. This is simply because the opportunity set for a global manager is so much greater than for a domestic manager. Adomestic manager is a hostage to fortune whereas a global manager is master of his destiny. Domestic bond managers have no choice but to accept the local interest rate structure, whereas global bond managers can pick and choose the most favourable countries. History has shown that good global managers do indeed outperform their domestic counterparts by a wide margin.
It has been suggested that the advent of European Monetary Union (EMU) has shrunk the opportunities available for global bond management. However, even allowing for EMU, there continues to be a wide dispersion of returns between international bond markets, much wider than the dispersion of returns within a domestic bond market.
Additionally, international credit and emerging markets are flourishing, adding further to global opportunity. An active global bond manager can take advantage of this dispersion of returns to extend beyond the domestic opportunity frontier.
So how much can we expect sector returns to differ from the domestic index in any given quarter?
Ninety per cent of the time, various sectors within a domestic fixed income market will provide a quarterly return within plus or minus two per cent of the index. Contrast this with country performance where different countries of the JP Morgan Global index can be expected to have a quarterly return within plus or minus 10 per cent of the index. The probability of any individual sector outperforming the domestic index by 10 per cent in a quarter is so insignificant as to be effectively zero.
Having established that the global bond manager has unparalleled opportunity, several questions spring to mind:
- Why is the dispersion of returns so much greater for countries than for sectors?
- How can a global manager move beyond the opportunity frontier and exploit the excess opportunity set?
- Have global managers historically been able to exploit this excess opportunity?
Macro Factors Drive Relative Country Return
A domestic manager is constrained by the domestic macro-economic and interest rate structure with its relatively narrow range of performance across different sectors. Hence, it is difficult to escape from an index-like return and impossible to access a different macro-economic environment. A global manager, by comparison, can choose from a variety of macro-economic and interest rate environments across countries, giving a broad spectrum of returns.
The influence of macro factors is substantiated by the dispersion of country returns over longer periods. It is quite normal for country bond returns to diverge greatly, not only on a quarterly basis, but also over the medium-, long-, and very long-term.
Table 1 shows that performance can vary enormously within a small universe of countries. In this example, we have included only the bond markets of Canada, the U.S., the UK, Germany, Japan, and Australia. Over 20 years, the performance differential between the countries has been dramatic.
How Global Managers Can Exploit The Excess Opportunity Set
Accurate forecasting of bond returns is difficult, if not impossible. Any forecasts of bond returns must be treated with caution. Forecasts generated from suspect methodology or black boxes require an even bigger health warning. Such ‘information’ is unlikely to be of much use to the asset allocation process.
The beauty of global management is that it is not necessary to be able to forecast accurately every bond market or, indeed, any bond market. A global bond allocation does not require fixed assumptions about the return of any individual bond market. With bond markets producing varying returns over all time horizons, the global manager’s job is to be able to identify those countries where relative performance is likely to be attractive and take advantage of this.
If macro factors are driving relative returns, then it is essential for a global bond manager to identify what these key macro factors are and how they influence relative return. It should then be possible to identify which countries have the most favourable macro environment and are, therefore, likely to generate the most favourable returns.
It is the relatively healthy countries which will produce the relatively healthy bond and currency returns. Of course, a country’s relative health will change over time, but, typically, changes will be gradual and it may take a number of years for a country to move from being one of the healthiest to one of the least healthy countries. Probably the most important indicator of a country’s financial health is its debt dynamics, both internal and external. A country which has stable, or improving, debt dynamics (falling debt) is considered healthier than one which is exposed to a rising or even explosive debt path.
Dependence on foreign savings is generally considered undesirable, although dynamics are again important. It is also necessary to understand the nature and motivation of international capital flows.
Among the other factors which we would emphasize as being important in determining relative health are a country’s monetary framework and ability to generate real wealth. Sensible monetary policies and appropriate monetary growth will promote the stability which is always welcomed by financial markets. An ability to generate real wealth is necessary to service and repay debt. However, economic growth which merely involves unsustainable resource utilization, excessive current consumption, and borrowing does nothing to enhance future debt prospects and is not indicative of relative health.
Global Bond Managers Have Exploited The Opportunities
When consultants or asset allocators look at global bonds, or indeed any asset class, they tend to base their decisions on the assumption that asset classes deliver index returns. This might seem like a fair assumption, but it completely overlooks those excess opportunities that global bonds offer for outperforming the index. Not only do global bond managers have these opportunities, but typically they have been able to take advantage of them and deliver above-index returns.
There will also be increasing opportunities in the fields of emerging markets and international credit.
Following the demise of Communism, the number of countries playing an active part in the global economy has increased rapidly. Many developing countries have made enormous efforts to restructure their economies to promote financial health, which will eventually produce a sustained trend towards the prosperity of developed countries. Global trade is seen as a prime driver. With the embracing of free market principles, more and more currencies are becoming convertible and local capital markets are developing on the back of this. The growth of the capital markets – and significantly, the growth in dependence on capital markets – itself reinforces the move toward greater policy discipline.
The Euro Credit Market
The U.S. has the biggest and most developed bond market in the world. Nonetheless, it still accounts for less than half of the world bond market and this proportion is set to shrink in the years ahead. The increased issuance, particularly in Europe, provides global managers increasing opportunity to add value through an allocation to Investment Grade Credit, just as U.S. domestic managers do now. The process of substitution of securities for bank loans – that has been evident in the U.S. – will be repeated in Europe, perhaps more aggressively.
Risk-Favourable Characteristics Of Global Bonds
An ideal asset class not only generates attractive returns, but can also have attractive risk characteristics when added to an existing portfolio. In seeking diversification, what we are looking for is an asset class with low correlation with other assets in the portfolio.
Global Fixed generally has a low correlation with other asset classes. Of particular interest, given the high allocation of pension funds to domestic equity, is the low correlation of global fixed income to Canadian equities.
However, this does not reveal the whole story. Diversification away from domestic equities is really only important when domestic equities are faring poorly. What is especially appealing about global bonds is how well they perform when the Canadian stock market falls. Since 1985, there have been 26 quarters in which the S&P/TSX index has declined. In 20 of these quarters, global fixed income has produced a positive return. During stock market setbacks, the correlation between the S&P/TSX and the Citigroup World Government Bond Index is negative with a coefficient of minus 0.48.
We are not saying that domestic bonds are not a good diversifier in a stock portfolio, but that global bonds are so much better.
In addition, as with other developed economies, changing demographic trends are also set to play an important role in determining future growth prospects. In such an environment, global bonds would outperform not only equities, but also domestic bonds.
The opportunity set for global fund managers is much wider than for domestic fund managers. This is where the value added from the ‘global bonds’ asset class comes from, where the alpha of a competent global fund manager is generated.
John Makowske is a partner and global credit analyst at Rogge Global Partners.
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