Issue: April/May 2006
INTERNATIONAL BONDS ARE DEAD. Long may they live!
Investec Asset Management strategist Michael Streatfield advises a fresh look at international bonds as developed markets begin to anticipate a rise in interest rates.
With inflation beaten off, international bonds have had a glorious reign. As interest rates have fallen, these bonds have produced solid returns. Times have been good, but for them new dangers are now beginning to stir.
Lower interest rates mean less room for movement to make money. Technology, such as automated dealing systems, and increased sophistication of market players have sharpened competitiveness.
International bonds have been a good diversifier for South African assets. Trustees have been keen to hold government bonds of developed markets internationally. Robust and secure, this looked like a good home for foreign assets. However, trustees need to be aware that the international bond space is moving both in terms of cycle and product.
Bond prices are driven by concerns around inflation and short-term interest rates. In developed markets, the global interest-rate cycle is turning upwards and rates are due to rise. Concerns over inflation – whether due to oil or commodity prices – are also pressurising developed-market bond yields in particular.
Bond prices are also driven by demand and supply. International defined benefit (DB) pension funds concerned about deficits and accounting standards have tried to match their liabilities by buying at the long end of the bond market. This increased demand has also depressed yields. So the international bond warriors have to strap on their rusted armour and trot out of the now wilting green pastures in search of fresh and bold new challenges. This search for yield in the bond space means bond mandates are getting more interesting than ever before.
HERE’S WHAT WE’RE SEEING:
- Wider mandates; allow more flexibility. Set for disappointment are trustees who have international bonds trapped in low-risk, conventional government bond mandates relying solely on movements in interest-rate direction (duration). In a rising interest rate environment, bond prices will fall and returns will be meagre. Investment managers are aware of this and are looking at ways of exercising more discretion to protect the value of portfolios. Within bonds, there is more work done on ‘curvature’ (profiting from changes in the shape of the structure of interest rates). Outside of conventional bonds, investment managers are taking bolder off-benchmark bets such as investing in some inflation-linked bonds. Listed property or preference shares can be introduced to provide other sources of return.
In the international bond space, times are more interesting than usual. Trustees should look to the words of strategist Sun Tzu: “Opportunities multiply as they are seized.”
- Emerging market bonds; increase returns and risks by playing in other countries’ debt markets. Some countries are considered riskier than others dependent on the strength of their economies, their level of indebtedness, history and ability to repay interest and capital. Emerging-market government bonds have higher yields than developed markets. Ironically, these spreads have been coming down. Developing economies look less risky as they adopt sound macro-economic policies and grow well. Trustees should ensure that they widen their international bond exposure to a wider spread of government issues.
- Corporate debt; invest in the debt of companies (also known as credit). Lending to businesses is never as safe as lending to governments. Governments can always raise taxes to pay their debts, but businesses must find customers and make sure they buy the things they can sell to make money. There is increased demand for credit risk by investors to enrich yields in a lower-return environment. This market is growing. However, a real danger is that economic conditions for companies worsen when interest rates wise. Trustees, be wary of relying solely on this at present.
- Hedge fund exposure. Some Trustees have opted for funds of hedge funds instead of bonds. They hope to achieve stable returns at low levels of risk. Hedge funds of funds have disappointed over the past two years so this is not the panacea previously hoped. Many trustees are put off by the increased complexity and understanding needed to get to grips with these funds.
- Product innovation. Instead of polishing rusted armour, some investment managers are facing the challenge of lower interest rates head-on and are developing solutions specifically to tackle this new bond arena. These managers are creating absolute-return fixed-income funds: first, to invest in the wide spread of fixed-income opportunities to lessen exposure to duration; second, the funds use index derivatives to further protect their funds from market exposure. The result is a
well-armoured yet flexible fixed-income fund that is not constrained in a single space to generate value. The success of these approaches will be seen as we move through the interest-rate cycle.
ACTIONS FOR TRUSTEES
- Check product ﬂexibility: Trustees need to look at their existing international bond investments and make sure the mandates for their products are sufﬁciently ﬂexible to adapt to changes in international bond markets.
- “Don’t worry we are balanced”: Trustees must still ask questions, even if they are invested in a global balanced product. The bond market has undergone signiﬁcant changes and products bought ﬁve years ago may be investing in old-style funds. Be
discerning! Ask how the bond bit works.
- Review new products: Bonds are no longer boring. Trustees need to be aware of new bond product designs, such as absolute
return, on the market that can better protect value when global interest rates rise.