Many are loosening portfolio guidelines to snag opportunities
The upside potential for core government bond investors in major developed nations is shrinking, leading some to globalize their sovereign debt investment strategy to reduce risk while adding potential sources of returns.
Investors are recognizing that “they should be diversified in what is essentially their lending activity across corporations and governments,” said Christopher Redmond, senior investment consultant and head of global bond manager research at Towers Watson & Co., London. “Historically, they lent to their local government and diversified within the corporate credit bucket. They're now attempting to diversify across global sovereign markets as well.”
In countries including the U.S., Germany, U.K., France and Switzerland, short-term real yields are at or below zero. There is a risk that investors are so concerned about global economic uncertainty that they're willing to essentially pay or receive next to nothing to lend to certain safe-haven governments, Mr. Redmond added.
“People are worried about the loss of principal; that's what we're seeing,” said Andrew Johnson, Chicago-based managing director and global head of investment-grade fixed income at Neuberger Berman Group LLC.
Prospects for further quantitative easing in the U.S., Europe and elsewhere are increasing as slow growth continues to threaten global recovery. As a result, interest rates are expected to remain low or dip slightly lower at least for the coming year, sources said.
But over the next decade, interest rates in major developed economies “generally have nowhere to go but up,” potentially resulting in capital losses for bond investors, said Michael Schlachter, Denver-based managing director at Wilshire Associates Inc.
“It makes sense to diversify globally even in a normal environment,” said Scott Mather, managing director and head of global portfolio management at Pacific Investment Management Co. LLC, Newport Beach, Calif. “We're not in a normal environment; we're in an unstable debt situation (globally) and risk reduction from the standpoint of a globally diversified sovereign bond portfolio becomes even more important. Investors who aren't doing this are essentially ignoring a free lunch.”
“There's no reason why half (of the average pension fund portfolio) shouldn't be invested in global bonds,” Mr. Mather added.
Some large investors — including those in the U.S. — are looking at their sovereign bond portfolios in a new light.
Among those that have recently appointed global fixed-income managers to diversify away from domestic government bonds are: the $89.9 billion New York State Teachers' Retirement System, Albany; the $14.8 billion Kentucky Teachers' Retirement System, Frankfort; and the £9.23 billion ($14.6 billion) British Coal Staff Superannuation Scheme, Sheffield, England.
“The goal is to introduce currency diversification to our fixed-income portfolio,” Kevin M. Carrico, deputy chief investment officer at the Kentucky fund, said in an e-mail. Within the next few months, the Kentucky pension plan is expected to fund a $200 million commitment to Rogge Global Partners to invest in non-U.S. dollar sovereign bonds and credit. The strategy is the fund's first such mandate.
For the most part, however, investors globally have a much heavier home bias in their bond portfolios than in their equity portfolios, managers and consultants said. One key factor is that investors often use domestic government bonds as part of a liability-driven investing solution and might be reluctant to take on foreign credit or currency risk, sources said.
According to the Wilshire Trust Universe Comparison Service, public plans in the U.S. allocated an average 31% of total assets to domestic fixed income but only about 1% to international fixed income as of Dec. 31. Among U.S. corporate plans, the average allocation to domestic fixed income is 37%, vs. about 2% to international fixed income.
“The average U.S. investor has plenty of equity exposure outside of the U.S., but that's not the case with sovereign debt, where there is much more of a home bias,” Mr. Schlachter said. “The issue is that (the country factor) drives investment outcomes in bonds much more so than in equities. ... If the U.S. is in a recession, Apple might do just fine because a large portion of the business is outside of the U.S. On the other hand, if the U.S. does poorly, U.S. debt is in trouble, period.”
Compared to a pure domestic sovereign bond portfolio, however, risk premiums can be more efficiently harvested in a broader global government bonds strategy, consultants said.
At Towers Watson, searches for global bond strategies “dwarf any regional searches, perhaps with the exception of domestic U.S. bonds,” Mr. Redmond said. Precise numbers were not available by press time, but this year, a growing number of Tower Watson's global bond searches are focusing on sovereign debt, he said. In comparison, previous global fixed-income searches targeted corporate bond strategies, particularly during the period following the 2008-'09 financial crisis.
“Mathematically, bond returns are likely to be less than they have been, leading a number of investors to change their approach” to core bond portfolios, said Nicholas Gartside, managing director and international chief investment officer for global fixed income at J.P. Morgan Asset Management (JPM), London.
For example, institutions now have less appetite for traditional global bond indexes, which are heavily weighted toward high-debt issuers such as the U.S., U.K., Japan and eurozone nations. In addition, investors are broadening their core bond portfolios to weigh more heavily on creditor nations — in particular, investment-grade emerging markets debt. J.P. Morgan's global bond assets stood at $148 billion as of June 30, up 20% since Dec. 31, 2010.
“We've gone through a number of phases,” Mr. Gartside said. In the first phase, interest rates are pushed to a very low level or near zero. In phase two, long-dated bond yields have decreased as a result of quantitative easing or similar measures. “Where we are now is in phase three, in which investors do two things. They start to go down the credit curve, looking at corporate debt because the extra yield is attractive. Secondly, there's the internationalization of the fixed-income market, and global bond managers are allocating on an opportunistic basis to places that they might not have done.”
While more managers are launching new strategies and building capabilities across the globe, sources warn this is an area in which depth of resources is crucial.
“In global equities, there are plenty of examples of managers able to develop and prove their expertise in this area without having (investment professionals) scattered all over the world,” said Marc Haynes, principal at Greenwich Associates in London. “In global fixed income, it doesn't quite work like that. Managers need to have people on the ground. ... The barriers of entry in this space are higher.”
Managers also need to demonstrate “a whole host of truly integrated analysis between emerging and developed countries,” Towers Watson's Mr. Redmond added. For example, credit ratings between Italy and South Korea are similar if not identical. “Ten years ago, (managers) wouldn't have needed to make that kind of analysis,” he added, “as the sovereign debt mandates were exclusively focused on developed markets.”
In July, Neuberger Berman introduced the new Neuberger Berman Global Bond Fund, seeded by an institutional investor with an initial investment of about $68 million. Mr. Johnson declined to name the investor. The fund is actively managed to diversify away from lower-yielding developed countries and includes some emerging markets sovereign bonds. Furthermore, additional alpha opportunities are possible through an active currency overlay.
Western Asset Management Co. in August launched a global sovereign total-return strategy, which targets a return of 6% to 9% per annum over a full market cycle. The strategy focuses on “countries with attractive yields and currencies, and where the underlying fundamentals are solid and improving,” said Gordon Brown, portfolio manager on the global markets team at WAMCO, which has about $16 billion in assets under management in global bonds strategies.
“We own none of the core government bonds that dominate (the Barclays Capital Global Aggregate Bond index) such as U.S. Treasuries, eurozone government bonds, U.K. gilts and Japanese bonds,” said Mr. Brown, who is based in London. “When we do have allocations to AAA bonds, we're invested in countries such as Australia and Sweden, where the fiscal and growth outlook is better.”
At PIMCO, the Global Advantage Strategy Bond Fund — an institutional fund introduced in 2009 and benchmarked to the firm's customized PIMCO Global Advantage Bond index — has grown to about $4.7 billion as of June 30.
A third of the portfolio is invested in emerging markets bonds. Mexico, for example, is “an ideal emerging country to consider in that the debt dynamics look much better than many developed countries,” Mr. Mather said. Ten-year bonds issued by Mexico are yielding 5% to 6%, compared to “the 1.5% range” coming from 10-year U.S. Treasuries.
“These are countries that may not have been thought about 10 years ago,” Mr. Mather added, “but investors should be thinking about them in the next 10 years.” n
Data Editor Timothy Pollard contributed to this article.
This article originally appeared in the September 3, 2012 print issue as, "Investors go global in sovereign bonds".