Managing global fixed income in a negative-yielding world
Bear with me for a second as I review some investors’ “favourite” (predominantly negative yielding) bond market: Japan. At the start of this year, the universe of Japanese government bonds yielded somewhere in the vicinity of 0.3%. Today, they yield -0.1%. That drop in rates translates into local currency returns of approximately 6.7%. For Canadian investors who did not hedge away the Japanese yen exposure, those returns have actually been upwards of 17% as the yen has been the best performing G10 currency year-to-date. In contrast, the Japanese stock market has fallen significantly over the same period. This highlights one of the strongest arguments for continuing to invest in fixed income: diversification of risky assets. Global government bonds continue to be the ultimate diversifiers to risky assets (such as high yield and equities) by exhibiting strong negative correlations and, therefore, continue to play an important role in prudent portfolio management.
With a greater portion of “risk-free” developed global government bonds yielding negative, fewer investors feel warm-and-fuzzy about fixed income. However, low (or negative) interest rates have merely exposed the underlying risk factors (and thus the underlying investment opportunity set) of this versatile asset class. Many risk dimensions are prevalent in global fixed income including duration, curve, currency, spread, volatility and inflation. The ability to diversify, tactically allocate to and prudently manage across various risk drivers is absolutely crucial in today’s negative-yielding world. Our advocacy for diversification of risky asset classes via fixed income also lends itself well to our strategy within global fixed income as we aim to diversify the risks that have been brought to light in the absence of income. Below, we shed some light on our strategy.
Global government bond universe
Our global bond strategy is benchmarked to the J.P. Morgan Global Government Bond Total Return Index (currency unhedged). It consists of 40% of U.S. Treasuries, 27% European government bonds, 23% Japanese government bonds, 7% U.K. government bonds and the remaining 3% in Canadian, Australian, Swedish and Danish government bonds. The overall index duration is roughly 8.25 years. This means that for every 1% drop across the universe of global (developed) interest rates, an investor would realize positive capital returns of roughly 8.25%.
Tactical positioning in Signature’s global bond strategy
The following is a year-to-date review of our positioning across the four most significant risk exposures within our global bond strategy: duration, currency, spread and volatility.
The strategy’s currency positioning (relative to the benchmark) maintains a noticeable overweight to the Canadian dollar (CAD) at the expense of U.S. dollar (USD) exposure. We ramped up the strategy’s CAD exposure around the time that the USD/CAD level broke through the start of year levels. As currency is by and large the most volatile component of any global strategy, maintaining an evenly distributed currency profile is a prudent approach to protecting the strategy’s absolute (total) return.
The slide in risky assets at the start of the year ultimately led to a review (and subsequent relent) of monetary policy tightening from the Fed in mid-March. It was around this time that we increased the strategy’s overweight in duration (relative to the benchmark) from a modest 0.3 years to over one year by mid-April. As interest rates collapsed to all-time lows following the U.K.’s vote to leave the European Union at the end of June, we pared back the overweight duration.
Although the strategy has maintained some exposure to investment grade corporate bonds over the years, emerging markets (EM) is our preferred asset class to express views on spreads. More specifically, we invest in USD-denominated EM sovereign bonds. As global interest rates have made new lows and as global central banks have continued to ease monetary policy, we increased our allocation to risky assets by increasing the strategy’s EM weight.
You have undoubtedly heard of the “lower for longer” argument with respect to global interest rates (a by-product of central bank policy actions). However, a very significant consequence of said policies over the past decade has been suppressed volatility. Notice in the chart below that implied U.S. 10-year interest rate volatility fell noticeably around the end of January/beginning of February when the Bank of Japan backstopped the slide in global risky assets by introducing negative interest rates. As implied volatility fell back to start of year levels, we began investing in U.S. federal agency mortgage-backed securities. This asset class enables us to take a view on the volatility of interest rates. The securities we have purchased as part of the strategy’s current 7.5% allocation will outperform if interest rates remain range-bound.
Year-to-date performance of Signature’s global bond strategy
By taking advantage of the full spectrum of available risk factors, our global bond strategy has delivered various forms of alpha. Year-to-date the portfolio has returned 5.48%, which is 1.08% over the benchmark. Our overweight duration position combined with the collapse in global interest rates has resulted in 0.66% of alpha returns although this was partly offset by currency positioning which has detracted -0.13% from performance. Our diversification efforts and security selection decisions have been successful and contributed a combined 0.55% of alpha returns. This 0.55% of alpha returns has been distributed across developed government bonds (0.27%), investment-grade corporates (0.15%), USD emerging market sovereign bonds (0.1%) and mortgage-backed securities (0.02%).
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rate of returns is the historical annual compounded total return including changes in share or unit value and reinvestment of all dividends or distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.