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.”