For many investors, an allocation to government bonds is the starting point for portfolio construction. When that allocation is expected to return nearly nothing over the next 10 years, the task of constructing a satisfactory portfolio is just that much more challenging. That said, a likely path for improving long-term potential returns in global government bonds is to be thoughtful and disciplined in allocating to country exposures.
Bond markets are built on the premise that issuers can borrow against the future, and some countries seem to be borrowing from a future far less rosy than thorny. With both high starting debt burdens and demographic trends associated with significant off-balance-sheet future borrowings combined with a reduced ability to spur growth, advanced economies such as Japan and the United States face major impediments to managing their ballooning national debt burden in the future. Yet, the debt of these countries dominates government allocations in traditional bond indices as a mechanical byproduct of their dominance in cumulative notional issuance.
Over the last few years, investors have been rewarded for their substantial exposure to these countries. A combination of bond-buying programs by central banks, negative- and zero-interest-rate policies, and continued fears that a new global crisis may be around the corner (a hard path to Brexit being the latest source of such concern) have held the pedal down on the flight to safety. Perhaps conditions will remain in place for investors to benefit from these allocations, but the possibility for retrenchment can also be convincingly argued: bond markets allow creditors to borrow against the future, and eventually the future tends to conform to harsh (but logical) economic realities, not feel-good hopes and fictions.1
Investment professionals are familiar with the saying “don’t fight the Fed.” While this may aptly apply to traders, long-term investors can be less heedful of this admonition. Those with long-term investment horizons can benefit by gaining exposure to bond strategies that allocate to countries on the basis of debt-servicing economic resources rather than debt issuance, effectively raising the relative credit quality of holdings. Gaining exposure to the less popular, less prolific issuers, not widely viewed as safe harbors in a volatile world, also allows long-term investors to capitalize on market inefficiencies.
Investors who position their portfolios to benefit from the reassertion of long-term economic realities may not find it comfortable or profitable in the short term. For instance, in the year ending September 30, 2016, the Citi RAFI Sovereign Developed Market Bond Index, an index that anchors on fundamental measures of a country’s size relative to the world economy, underperformed an issuance-weighted index by approximately 1.5%. The underperformance was driven by a substantial underweight to Japanese debt just when the country was experiencing an extraordinary bond rally engineered by the Bank of Japan’s quantitative easing program.2 The average weight to Japan in the fundamentally weighted index was roughly 9% versus 30% in the cap-weighted index over the 12-month period.
We would not expect the recent underperformance to continue indefinitely, but neither can we predict when the tide will turn in favor of fundamentally weighted developed sovereign bond indices.3 Investors, for example, who have taken the position that Japan’s interest rates will imminently reverse (after a protracted 20 years or more hovering at zero or just above) have entered into a trade notoriously known as “the widow maker.” Our preference would be to protect our families from such a fate.
In global government bond markets today, investors seem to be standing atop tectonic plates, which are moving slowly yet predictably, defying simple rules of thumb about risk-free investing, and rendering the last 40 years of historical data a very poor guide for making decisions about the future. In the current vacuum of relevant historical experience, investors who choose a strategy that follows a rules-based methodology which emphasizes debt-service capacity, capitalizes on observable inefficiencies, and implements at low cost, should be well-positioned to weather the era-defining changes likely ahead.
Improving High-Yield Bond Portfolio Returns
Investors in corporate credit, especially high-yield bonds, tend to face shorter cycles of booms and busts than do government bond investors, and therefore have more frequent opportunities, as a result of year-over-year price volatility, to advantageously position their portfolios. High-yield bonds are an equity-like asset class, whose returns are overwhelmingly driven by credit spreads and credit losses, not rates and duration.
The Research Affiliates expected returns methodology suggests that, as of October 31, 2016, the Barclays US High Yield Index, a traditional cap-weighted index, is expected to return 2.2% over the next 10 years, after inflation and credit losses. The wide range of outcomes around the 2.2% central tendency falls between −0.3% and 4.7%.
Empirically robust and theoretically sound reasons support the belief that investors can do better than traditional high-yield index strategies. In fact, rules-based alternative strategies may go a long way toward capturing potential excess returns in the high-yield space. Such strategies follow two key principles, which mirror factor investing in equities, especially the intersection of quality and value, as discussed by Kalesnik and Kose (2014):
- Avoid the unrewarded risks of reaching for yield farther out on the credit-quality scale, and
- Take advantage of temporary mispricings by trimming recent winners and adding to recent losers.