CHAPTER
FIFTY-THREE
INTERNATIONAL BOND PORTFOLIO MANAGEMENT

KARTHIK RAMANATHAN

Senior Vice President
Fidelity Management and Research Company/Pyramis Global Advisors

JAMES M. GERARD

Quantitative Research Analyst
Fidelity Management and Research Company/Pyramis Global Advisors

FRANK J. FABOZZI, PH.D., CFA, CPA

Professor of Finance
EDHEC Business School

This chapter will focus on international bond investing and the many complex factors portfolio managers need to consider when allocating assets to this sector of the fixed income market. After addressing the fundamental building blocks of international portfolio management, including currency risk and benchmark selection, the tools used to generate excess return are described, including management of currency exposure, interest rate management, and sector and security selection.

Strategic and tactical asset allocation are then defined from a fundamental-based investment approach, which leads to the central topic of portfolio construction. Portfolio construction encompasses many components and must fully address the interactions between risk factors active in international bonds. Each component of risk, including currency, interest rate, and security selection, can be broken down analytically. Since the decision to hedge currency risk is the most important determinant of risk and return facing a portfolio manager, the subject is considered in detail before turning to a discussion of the determinants of forward rates and an example of break-even analysis. The analytical foundation of these sections is the framework used by international bond portfolio managers to support investment decision-making, attribute performance, and assess portfolio exposures.

The authors would like to thank Ben Tarlow and Curt Hollingsworth of Fidelity Management and Research Company for their assistance in this chapter. In addition, Christopher B. Steward and J. Hank Lynch were significant contributors to this chapter through their work in previous editions, and sections of this chapter are adapted from those works.

While many of the examples and illustrations in this chapter apply to international investing from the perspective of a U.S. manager investing in bond markets outside the United States, it is important to keep in mind that the principles apply to any cross-border manager investing outside his domestic bond market. The same issues faced by U.S. managers regarding currency management apply to managers throughout the world when they invest in bonds in which the cash-flows are not denominated in their local currency.

Furthermore, to provide a broad overview of the many aspects of international fixed income investing in one chapter implies that many topics do not receive the depth of discussion they deserve. For example, the topic of currency management is extensive and continues to be a subject of significant debate. We provide only an overview of the fundamental principles here.

OVERVIEW OF INTERNATIONAL BOND MARKET INVESTING

As the breadth and liquidity of fixed income markets outside of the United States continues to grow, investors have increasingly included these securities in their portfolios. These allocations to international bonds offer portfolio diversification and broader opportunities for adding returns. Moreover, as the sophistication of investors evolves through broadened research coverage, robust risk analytical systems, and increased competition for returns, ignoring opportunities in this investable universe simply is not an option.

Many substantial shifts have occurred which have also increased the prominence of global bond markets. The Brady bond market, which resulted from the Latin American crisis of the late 1980s, and the Asian debt and currency crisis, which led to multiple sovereign defaults in the 1990s, gave way to the use of a common currency in Europe in 1999.

Some investors were concerned that the diversification benefits of global bond investing would be diminished by the commencement of the European Monetary Union (EMU) in 1999. But in fact the economies of continental Europe were already very closely tied together before the EMU, with most European central banks following the interest-rate policies of the German Bundesbank for several years before the move to a single currency.

Thus the impact on diversification of a global bond portfolio caused by the EMU was minimal. EMU, however, created a more robust credit market in Europe as issuers and investors, no longer confined to their home markets, access a larger, more liquid pan-European bond market. Corporate bond issuance increased sharply in Europe, and led toward a broader range of credits and instruments similar to those available in the U.S. bond market.

Just as the EMU was a major focus in the early part of the decade, the rise of Asian bond markets once again broadened the investment opportunities in global bond markets. Major sovereigns including South Korea, Mexico, and Brazil are regular issuers in the bond markets. Importantly, corporations and other institutions within each country are available to access liquidity in both local and non-local currencies.

As the Chinese economy continues to open to investors, and liberalization of the financial system proceeds, offshore and onshore currency trading in the Chinese renminbi will continue to propel this growth. This massive growth in the local currency debt market—and the potential returns associated with both lower interest rates and currency appreciation—have given investors many reasons to enter the international bond markets.

At the same, while the benefits of investing in international bonds certainly are apparent, the risks associated with investing in these markets need to be well understood. Given the many bouts of volatility and capital losses that investors have faced in the past few decades, an allocation to this sector requires a more robust investment process. Management of an international bond portfolio poses more varied challenges than management of a domestic bond portfolio. Differing time zones, local market structures, settlement and custodial issues, and currency management all complicate the fundamental decisions facing every fixed income manager in determining how the portfolio should be positioned with respect to duration, sector, and yield-curve.

The fundamental activities in any investment management process are setting investment objectives, developing and implementing a portfolio strategy, monitoring the portfolio, and rebalancing the portfolio as needed. A well-defined, disciplined investment process is needed to address the additional complexities posed by cross-border investments versus those faced in domestic bond markets. Addressing these challenges is crucial to the investment management process.

INVESTMENT OBJECTIVES AND POLICY STATEMENTS

Most investors are attracted to global bonds as an asset class because of their historically higher returns than U.S. bonds. Others are drawn to global bonds because of their diversification value in reducing overall portfolio risk. An investor’s rationale for investing in international bonds is central to developing appropriate return objectives and risk tolerances for a portfolio.

Broadly speaking, investor specifications include return objectives and risk tolerances. Each of these investment objectives has implications for the management of an international bond portfolio and should be reflected in the investment policy statement.

Global bonds initially were just a small part of an overall portfolio added for both return and diversification. As investors have gained a better understanding of international bond markets over the past two decades, allocations to the asset class have increased. The strategic asset allocation for a portfolio is made up of benchmarks that both define the asset class and provide a performance target that each investment manager strives to outperform. Return objectives often are expressed in terms of the benchmark return, for example, benchmark return plus 100 basis points over a market cycle.

The return objectives and risk tolerances will indicate not only the most appropriate benchmark, but also the most suitable investment management style. Investors who are concerned primarily with diversification may wish to place tight limits on the sizes of positions taken away from the benchmark to ensure that diversification is not weakened. A total-return-oriented investor might be far less concerned with diversification and focused on absolute return rather than on benchmark relative return.

Investment policy statements should be flexible enough to allow the portfolio manager sufficient latitude for active management while keeping the portfolio close enough to the benchmark to preserve the desired top-down asset allocation. The policy statements should address allowable investments, including:

1. The countries in the investment universe, including emerging markets

2. Allowable instruments, including mortgages, corporate bonds, asset-backed securities, and inflation-adjusted bonds

3. Minimum credit ratings

4. The currency benchmark position and risk limits

5. The use of derivatives such as forwards, futures, options, swaps, and structured notes

The time horizon for investment performance is also important. A short-term time horizon, such as a calendar quarter, may encourage more short-term trading, which could diminish the natural diversification benefit from international bonds as an asset class. Investors who emphasize the risk-reduction or diversification aspect of international bond investing should have a longer time horizon of perhaps three to five years. Since economic cycles can be prolonged, this provides enough time for a full economic cycle to add any diversification benefit.

Benchmark Selection

Benchmark selection for an international bond portfolio has many ramifications and should be done carefully. As is the case when choosing an international equity benchmark index, the choice of a pure capitalization (market value) weighted index may create a benchmark that exposes the investor to a disproportionate share in the Japanese market given the enormous size of the market relative to the investor’s liabilities or diversification preferences. A global bond portfolio, which for a U.S.-based investor includes some allocation to dollar denominated domestic debt in addition to international debt, could increase the investable universe for bond managers—but returns and even diversification benefits could be reduced.

While international equity indexes chosen for benchmarks are most often quoted in the investor’s local currency (i.e., unhedged), international bond benchmarks may be hedged, unhedged, or partially hedged, depending on the investor’s objectives. The choice of a hedged, unhedged, or partially hedged benchmark likely will alter the risk and return profile of the investment portfolio and should reflect the rationale for investing in international bonds.

Available Benchmarks

Benchmarks can be selected from one or a combination of the many existing bond indexes:

• Global (all countries, including home country)

• International (ex-home country)

• Government-only or GDP weighted

• Multisector or broad (including corporates and mortgages)

• Currency-hedged

• G7 only

• Maturity constrained, e.g., one to three years, three to five years, seven to ten years

• Emerging markets

Alternatively, a customized index or “normal” portfolio can be created. Some frequently used fixed income benchmarks are the Citigroup World Government Bond Index (WGBI) and the Barclays Capital Global Aggregate Bond Index. The benchmark often provides both the return objective and the measure of portfolio risk. Tracking error, the difference between the performances of the portfolio versus the benchmark, is one such measure of portfolio risk.

Benchmark Currency Position

Currency management is a matter of much debate in the academic literature. Investing internationally naturally generates foreign currency exposures. These currency exposures can be managed either passively or actively, although most global bond managers use active management to some degree.

Many managers are attracted to active currency management because of the large gains that can be attained through correctly anticipating currency movements. Since currency returns are much more volatile than bond market returns, even modest positions in currencies can result in significant tracking error. Some bond managers handle both bond and currency exposures, assuming that the same fundamental economic factors influence both bond yields and currency levels.

However, bonds and currencies frequently behave quite differently in reaction to the same external stimulus. As a result, actively monitoring and managing currency risk is in itself a significant role. Both the risks and opportunities posed by currency movements suggest that some specialization in currency is warranted, particularly as the allocation to international bond markets increases. For bond portfolios, exchange rate risk dominates overall volatility contributing up to 95% of total unhedged return volatility, explaining why practitioners tend to view hedging exchange risk in bonds as much more important.1

The first task is to determine the neutral or strategic foreign currency exposure appropriate for the investment objectives. Some of the academic research on currency hedging for U.S. dollar–based investors suggests that the risk-minimizing currency strategy for a global bond investor is close to a full currency hedge, with a modest long position in the U.S. dollar.2 In fact, currency hedging is sometimes described as a “free lunch” based on the argument that currencies add only volatility, but have zero expected returns.3

Other studies suggest that a partially hedged benchmark offers superior risk-adjusted returns as compared with either a fully hedged or unhedged benchmark.4 This latter research has led some to recommend a 50% hedged benchmark for either a passively managed currency strategy or as a good initial hedged position for an active currency manager. Interestingly, a 2004 survey by Russell/Mellon indicated that only about 13% of institutional investors use hedge ratios other than 0%, 50%, or 100%.5 Once the benchmark has been selected, a suitable currency hedge position needs to be determined.

For example, a U.S. dollar–based fixed income manager whose primary goal is risk reduction might adopt a hedged or mostly hedged benchmark that has historically shown greater diversification benefit from international bonds. Despite a higher correlation with the U.S. bond market than unhedged international bonds, hedged international bonds offer better risk reduction owing to a lower standard deviation of bond returns than a U.S.-only bond market portfolio.6

In addition, this lesser volatility of hedged international bonds results in more predictable returns. Conversely, an investor who has a total-return objective and a greater risk tolerance would be more likely to adopt an unhedged or mostly unhedged benchmark and allow more latitude for active currency management.

From the perspective of a U.S. investor, Exhibit 53–1 shows that for the 25 year period 1985–2010, the currency component of investing in unhedged international bonds accounted for much of the total return volatility. The international bond index used is the Citigroup WGBI excluding the United States (denoted by “non-U.S. WGBI”).

EXHIBIT 53–1
Hedged and Unhedged Returns: 1985–2010

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Investing in international bonds on a hedged basis reduced the return in most periods but also substantially reduced the return volatility. As can be seen in Exhibit 53–1, over the 25-year history of the WGBI, hedged international bonds returned less than unhedged international bonds and even lagged the U.S. component of the WGBI slightly. However, the volatility of the hedged non-U.S. WGBI was lower than that of the unhedged index and that of the U.S. component.

To compare returns on a risk-adjusted basis, we can use the Sharpe ratio.7 Despite the higher return of the unhedged non-U.S. WGBI, its risk-adjusted return was lower than the hedged index and the U.S. bond component alone for the whole 1985–2010 period.

As noted earlier, using a 50% hedged portfolio offers a compromise in that its return is virtually midway between the return of the unhedged non-U.S. WGBI and the U.S. bond component, with substantially lower volatility than the unhedged index, giving it a higher Sharpe ratio than the unhedged index. Of course, the relative performance of the hedged versus the unhedged index depends on the performance of the home currency (here the U.S. dollar), which can experience long cycles of strength or weakness.

The advantage of using a partially hedged benchmark versus a fully hedged or fully unhedged benchmark is illustrated in a mean-variance framework in Exhibit 53–2. We began by assuming that we could invest in any combination of the four asset classes highlighted in Exhibit 53–1. We used the (unweighted) sample returns, variances, and covariances of the four portfolios to construct the overall efficient frontier, and overlaid two subfrontiers that constrain the holdings to U.S. bonds + WGBI ex-U.S. (hedged), and U.S. + WGBI ex-U.S. (50% hedged).

EXHIBIT 53–2
Risk-Return for Unhedged and Hedged International Bond Portfolios (U.S. Investor Perspective) 1985–2010 Historical Returns

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From the standpoint of the U.S.-based investor, it is clear that adding an increment of 50% hedged global bonds substantially increased the overall portfolio return over the period, while keeping total portfolio risk very close to that of the U.S.-only portfolio. Indeed, in the neighborhood of U.S.-only portfolio risk, the U.S. + WGBI ex-U.S. (50% hedged) combination turned out to be very close to optimal.

It is important to keep in mind that these historically constructed efficient frontiers are more of an illustration than a guide to long-run portfolio construction. For example, the last row of Exhibit 53–1 shows how much the relationship between the hedged and unhedged portfolios have moved with time. The impetus for this move, of course, has been the secular global rates rally that has been in progress for most of the WGBI’s history. Also note that the financial crisis of 2007–2009 greatly upset traditional correlations among all asset classes, including currencies and interest rates.

Returns of partially hedged U.S.-based global bond portfolios have also benefited from the trend of depreciation in the U.S. currency relative to other major global currencies, particularly since the establishment of the EMU. With the convergence of global rates, and the likelihood of future—possibly significant—rate increases, global portfolio managers are going to have to adapt their country allocation and currency risk strategies. The sections to follow outline the analytical foundations of strategy formation.

Risk Limits

Many investment guidelines will include explicit risk limits on bond and currency positions as well as duration and credit risk. Exposure limits can be expressed either as absolute percentages or as weights relative to a benchmark. Increasingly, tracking error limits also have been used to set risk limits in investment guidelines.

Limits on investment in countries outside the benchmark should be specified at the outset. Despite the pitfalls of using duration to measure interest-rate risk across countries,8 risk limits on duration are nonetheless useful and should be established. The range of allowable exposures is often wider for bond exposures than for currency exposures.

Credit-risk limits, usually a minimum-weighted-average credit rating from the major credit rating agencies, and limits on the absolute amount of low- or non-investment-grade credits also should be included. Apart from default risk, the illiquidity of lower-rated securities may hamper a manager’s ability to alter exposures as desired. In the past, this was due to the lack of a liquid corporate bond market in many countries and the relative illiquidity of Eurobonds compared with domestic bond markets.

DEVELOPING A PORTFOLIO STRATEGY

Once the investment policy statement is established, the portfolio manager needs to develop a portfolio strategy appropriate to the investor’s objectives and risk tolerances. Just as in many other areas of investment management, portfolio managers often subscribe to different management styles or investment disciplines.

The performance of most portfolio managers is judged against the benchmark return, not absolute returns.9 There are a number of means by which portfolio managers can add to returns; however, the bulk of excess returns relative to the benchmark come from broad bond market and currency allocation decisions. A disciplined investment approach based on fundamental economic factors or market indicators of value facilitates the market and currency selection process. Once again, because of the historically high volatility of currency returns, the approach to currency management is a primary concern.

Styles of International Bond Portfolio Management

The challenges faced by international fixed income managers are different from those facing domestic fixed income managers. First, the international fixed income portfolio manager must operate in the U.S. bond market plus 10–20 other markets, each with their own market dynamics. Second, changes in interest rates generally affect different sectors of the U.S. bond market in much the same way (with the exception of mortgage-backed securities), although the magnitude of the changes may vary. However, international bond markets may move in different directions depending on economic conditions and investor risk tolerances.

International bond managers also use one or more different management styles. These can be divided into four general categories: the experienced trader, the fundamentalist, the black box, and the chartist.

The experienced trader uses his or her experience and intuition to identify market opportunities. The experienced trader tends to be an active trader, trying to anticipate the next market shift by international fixed income investors such as hedge funds, pension funds, and central banks. The basis for these trades is derived from estimates of market positioning and risk tolerances and supported by observation of market price movements and flow information. The experienced trader is often a contrarian, looking to profit from situations in which many investors may be forced to stop themselves out of losing positions.

The fundamental style rests on a belief that bonds and currencies trade according to the economic cycle. Sector rotation within corporate bonds also will be affected by the economic cycle, as different sectors perform relatively better at different points in the cycle. Some of these managers believe that the economic cycle can be forecast and rely mostly on economic analysis and forecasts in selecting bond markets and currencies. These managers tend to have less portfolio turnover because the economic fundamentals have little impact on short-term price movements. “Bottom-up” security selection in corporate bonds could also be characterized as a fundamentalist approach, even though it rests on issuer-specific fundamental analysis rather than on broad economic fundamentals.

The black-box approach is used by quantitative managers who believe that computer models can identify market relationships that people cannot. These models can rely exclusively on economic data, price data, or some combination of the two. Quantitative managers believe that using computer models can create a more disciplined investment approach that, because of other managers’ emotional attachment to positions, their lack of trading disciplines, or their inability to process more than a few variables simultaneously, will provide superior investment results.

Some investors called chartists, technical analysts, or technicians, may rely primarily on technical analysis to determine which assets to buy or sell. Chartists will look at daily, weekly, and monthly charts to try to ascertain the strength of market trends or to identify potential turning points in markets. Trend-following approaches, such as moving averages, aim to allow the portfolio manager to exploit market momentum. Countertrend approaches, such as relative-strength indexes and oscillators, try to identify when recent price trends are likely to reverse.

Very few international bond portfolio managers rely on only one of these management styles, but instead use some combination of each. Investment managers who rely on forecasts of the economic cycle to drive their investment process will from time to time take positions contrary to their medium-term strategy to take advantage of temporary under- or overvaluation of markets identified by technical analysis or estimates of market positions.

Even “quant shops” that rely heavily on computer models for driving investment decisions will sometimes override the model’s decisions and look to other management styles to add incremental returns. Regardless of the manager’s investment style, investment decisions must be consistent with the investor’s return objectives and risk tolerances and within the investment guidelines.

International bond portfolio managers would do well to maintain a disciplined approach to buy and sell decisions. This would require each allocation away from the benchmark to have a specified price target (or more often yield spread or exchange-rate level) and stated underlying rationale. Depending on the management style, the size of the position should reflect the strength of the investor’s conviction or model’s signal.

As long as the investment rationale that supported the initial decision remained unchanged, the position would be held or potentially increased if the market moves in the opposite direction. Each trade should be designed with consideration for the relevant bond yield or exchange rate’s behavior through time. For example, an exchange rate that exhibits a tendency to trend will require a different buy and sell discipline than one that tends to consistently revert back to an average level.

SOURCES OF EXCESS RETURN

The baseline for any international bond portfolio is the benchmark. However, in order to earn returns in excess of the benchmark, after management fees, the portfolio manager must find ways to augment returns. These excess returns can be generated through a combination of five broad strategies:

1. Currency selection

2. Duration management/yield-curve plays

3. Bond market selection

4. Sector/credit/security selection

5. Investing in markets outside the benchmark (if permitted)

Each of these strategies can add to returns; however, currency and bond market selections generally provide the lion’s share of returns. We discuss each of these sources of excess return below.

Currency Selection

Most investment guidelines allow for some active management of currency exposures. The attraction of active currency management is strong because potential gains are so large. Since the volatility of currency returns is generally higher than that of bond market returns, the incremental returns gained from currency exposures must be evaluated relative to the additional risk incurred.

For an active currency management strategy to consistently provide superior risk-adjusted performance, a currency forecasting method is required that can predict future spot rates (i.e., future exchange rates) better than forward foreign exchange rates (i.e., rates that can be locked in today using the market for forward contracts). Forward foreign exchange rates are not forecasts of future spot foreign exchange rates, but are determined by short-term interest-rate differentials between currencies.

Academic studies have shown that several strategies have been successful in generating consistent profits through active currency management. The fact that forward foreign exchange rates are poor predictors of future spot exchange rates is well established. Historically, discount currencies (i.e., those with higher interest rates than the investor’s local currency) have depreciated less than the amount implied by the forward rates, providing superior returns from holding unhedged positions in currencies with higher short-term interest rates. Overweighting currencies with high real interest rates versus those with lower real interest rates also has been shown to provide incremental returns.10

In addition, some currency movements are not a random walk but exhibit serial correlation (i.e., currency movements have a tendency to trend).11 In a market that tends to trend, simple technical trading rules may provide opportunities for incremental currency returns.12 These findings in several academic studies demonstrate that excess currency returns can be generated consistently, providing a powerful incentive for active currency management. At the same time, as currency markets have become more transparent and liquid, and these strategies have become more broadly known, the efficacy of standard techniques will likely diminish—requiring the evolution of more sophisticated approaches.

Duration Management

Although closely aligned with the bond market selection decision, duration management also can enhance returns. Bullet versus barbell strategies in a curve-steepening or -flattening environment within a particular country’s bond market can enhance yield and total return. In addition to these strategies, which are also available to managers investing in their domestic bond market, the international fixed income portfolio manager has the option of shifting duration between markets while leaving the portfolio’s overall duration unchanged.

Tools to manage duration in international bond portfolios have become more widespread over the past few decades. The interest-rate swaps market is generally very liquid across international bond markets and used extensively by institutional investors to manage rate risk. Interest-rate futures, available in most markets, offer a liquid and low-cost vehicle for changing duration or market exposure quickly. More liquid government bond issues and the development of strip markets (which separate government bond cash-flows into individual interest and principal payments) also assist portfolio managers when managing duration exposure.

Bond Market Selection

Excess returns over the benchmark index from overweighting the best-performing bond markets can be extremely large. International bond portfolio managers apply many techniques to identify these bond markets, including macroeconomic forecasts, quantitative models, and sovereign risk. Relative value opportunities can result from market dislocations, illiquidity, and lack of full information, resulting in attractive entry points for bond managers.

Sector/Credit/Security Selection

Some global bond indexes include only government bonds, but others, such as the Barclays Global Aggregate and the Citigroup Global Broad Investment Grade Indexes, incorporate other instruments, including corporate bonds and mortgages. As corporations look to access liquidity beyond their domestic investor base and issue in international markets, the overall corporate bond market has become an even more attractive source of return for portfolio managers.

Those managers who typically apply a core “bottom-up” research approach to identifying value base on credit fundamentals can now focus on an even broader universe of securities. Similarly, mortgage bonds, high-yield debt, covered bonds, and asset-backed securities can offer incremental opportunities for return. In certain environments in which markets are trendless or the rate environment is fairly stable, sector and security selection can be drivers of return versus duration management.

Investing in Markets Outside the Index

If allowed by investment guidelines, allocating assets to markets outside the index can enhance returns significantly without dramatically altering the risk profile of the portfolio. For example, a portfolio manager who uses the Citigroup World Government Bond Index as his or her benchmark would be taking out-of-benchmark bets if an allocation were made of corporate credit or mortgage debt.

The process for selecting an out-of-index market is similar to that followed by an active manager for a domestic bond portfolio when deciding whether or not to construct a portfolio with allocations different from the benchmark index and whether or not to invest outside the index. The manager will assess the potential performance on a total-return basis of the markets outside the index relative to that of the markets to be underweighted in order to allocate funds to out-of-index markets. An international bond portfolio manager, however, also must take into account the effect of currency movements and hedging decision of an investment outside or within the index.

THE FUNDAMENTAL-BASED INVESTMENT APPROACH

The portfolio strategy is often composed of a medium-term strategic allocation and a shorter-term tactical allocation. The strategic allocation is composed of positions held for one to three months or longer designed to take advantage of longer-term economic trends. A fundamental-based approach is used to develop the portfolio’s strategic allocation. The investment style used in the fundamental-based approach is, of course, the fundamental style, but also can be combined with a quantitative or black-box style to forecast relevant strategic factors.

The tactical allocation generally relies on technical analysis or flow information to identify shifts in market prices that are likely to occur within a few days to several weeks. Tactical allocations can be driven by expectations of a reversal in a recent price trend or continued price momentum. The experienced trader, black-box, and chartist investment styles most often use technical analysis combinations in their tactical allocation decisions.

The strategic decision of which bond markets and currencies to overweight usually begins with an economic outlook and bond and currency forecasts in each of the markets considered for investment. The long-run economic cycle is closely correlated with changes in bond yields, and trends in both the economic cycle and bond yields tend to persist for a year or longer. The potential returns that can be achieved by correctly forecasting economic growth or turning points in the economic cycle are significant. As a result, major financial firms and asset managers allocate many resources to these duties.

Forecasting interest rates, however, is extremely difficult. Academic literature generally holds that interest-rate forecasts are unable to generate consistent risk-adjusted excess returns. This is partly so because market prices can deviate substantially over the short term from the level consistent with the economic fundamentals. Economic fundamentals affect bond and currency prices over the medium to long term.

Also, the volatile nature of certain economic data series may result in exaggerated market reactions to individual data releases that may be different from the actual trend in the economy. These deviations may persist for several months until either the initial figure is revised or several subsequent data releases reveal the error in the initial interpretation.

The creation of an independent economic outlook can be useful in several ways. First, it can help to identify when market interpretations of the economic data are too extreme or add value through correctly anticipating economic shifts not reflected in the market consensus.

Second, since it is often not absolute changes in interest rates but changes in interest rates relative to other markets that determine the margin of performance in international fixed income investing, an independent economic outlook does not require accurate growth forecasts for each individual market but only economic growth differentials to be able to add value. Whether the portfolio will invest in U.S. bonds or not, the large influence of the U.S. dollar and the Treasury market on foreign markets underlines the importance of an independent outlook on the U.S. economy.

Thus the economic outlook forms the foundation for the strategic allocation to bonds and currencies. An economic outlook for each country should be constructed to assist in ranking the relative attractiveness of markets. However, even though economic fundamentals in a particular country may be extremely bond supportive, bond prices may be too high to make it an attractive investment.

Likewise, bonds are sometimes excessively cheap in countries with poor economic fundamentals and hence may provide an attractive investment opportunity. Thus the economic outlook must be compared with either consensus economic forecasts or some market value measure to identify and rank attractive investment opportunities.

The strategic allocation decision regarding which markets to overweight or underweight relative to the benchmark is thus a complex interaction of expected returns derived from assessing economic trends and technical and value factors. Each set of variables is defined and explored below, beginning with the fundamental factors used to create the economic outlook.

The main fundamental economic factors are cyclic economic indicators, inflation, monetary policy, fiscal policy, debt, balance of payments, and politics. Each factor needs to be evaluated against market expectations to determine its likely impact on bond prices and currency rates. Each of these factors is covered in considerable detail in books on macroeconomics and international economics.

Identifying trends in economic fundamentals can help to identify attractive investment opportunities in markets, but some yardstick to measure relative value is needed. Determining relative value is highly subjective. Three relatively objective value measures include real yields, technical analysis, and market sentiment surveys.

A real yield is the inflation-adjusted rate of return demanded by the market for holding long-term fixed income securities. Real yields can quickly be eroded by sustained inflation. Real yields are affected by a variety of factors, including supply and demand for capital as well as inflation expectations. Real yields are simply nominal bond yields minus expected inflation; however, expected inflation is often difficult to quantify.

Some countries, including the United States, have inflation-indexed bonds that pay a real rate of interest above the inflation rate. These bonds not only provide investors with some protection against a surge in inflation but also offer a means of gauging investor inflation expectations.13

Nominal bond yields deflated by current inflation, although not a precise measure of the market’s real interest-rate premium, are easily measurable and still can provide some useful insight into bond valuation. Real yields can be compared across markets or against their long-run averages, such as 5 or 10 years, in each market. The usefulness of real yields as a measure of relative value has diminished as global inflation rates have converged to very low levels.

Technical analysis can be as simple as drawing a trend line on a chart or as complex as calculating the target of the third impulse wave of an Elliott wave analysis. In addition to valuing bonds and currencies, technical analysis can be used to value everything from stocks to gold to pork bellies. What all technical analysis has in common is that it tries to predict future prices solely from examining past price movements. Most technical analysis models fall into one of two camps: trend following or countertrend. The former tries to identify trends that should persist for some period of time, and the latter attempts to predict when a recent trend is likely to change.

Market sentiment can be used as a contraindicator of value in the following way. A heavy overweight of a particular country’s bond market implies that fewer managers are likely to add to that market, and more managers, at least eventually, are likely to sell. Market sentiment can be estimated by investor sentiment surveys or by estimates of investment flows. Historic trends, as well as the overall levels, should be taken into account when assessing market sentiment.

For example, an indication that managers are underweighting Japanese bonds might lead some to conclude that Japanese bonds are due for a rally. Sentiment surveys, however, may not capture all market participants and therefore simply offer yet another metric for the international bond portfolio manager.

PORTFOLIO CONSTRUCTION

Translating the strategic outlook into a portfolio allocation requires a framework for assessing expected returns against incremental portfolio risk. Returns can be separated into three components: excess returns on bonds, excess returns on currencies, and the short-term risk-free interest rate. This component methodology can assist in identifying where market prices are most out of line with the economic outlook and whether bond market currency exposures should be hedged or be unhedged.

Components of Return

To explain the total return components of an international bond portfolio14 we will use the following notation. We will let “home currency” mean the currency of the manager. Thus, for a U.S. manager, it is U.S. dollars. For a Japanese portfolio manager it is yen. In the notation, the subscript H will denote home currency.

We will let “local currency” be the currency of the country where the manager has invested and use the subscript L to denote the local currency. Thus, to a U.S. portfolio manager, yen would be the local currency for bonds purchased in the Japanese bond market and denominated in yen, while for a Japanese portfolio manager, U.S. dollars would be the local currency for bonds purchased in the United States and denominated in U.S. dollars.

The expected total return of an unhedged international bond portfolio in terms of the home currency depends on three factors:

1. The weight of each country’s bonds in the overall portfolio

2. The expected bond market return for each country in local currency

3. The expected exchange-rate percentage change between the home currency and the local currency

Mathematically, the expected total return of an unhedged bond portfolio in terms of the home currency can be expressed as follows:15

Total expected portfolio return in manager’s home currency

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where

  N = number of countries whose bonds are in the portfolio

  Wi = weight of country i’s bonds in the portfolio (i = 1, 2, …, N)

  ri = expected bond return for country i in local currency (i = 1, 2, … N)

  eH,i = expected percentage change of the home currency with country i’s local currency

We will refer to eH,i as the currency return.

The expected portfolio return as given by Eq. (53–1) is changed to the extent the manager alters currency exposures relative to the country distribution of the underlying bond exposures. A common instrument used to alter exposure to exchange rates is a currency forward contract. The relationship among the spot exchange rate, the interest rates in two countries, and the forward exchange rate on a currency forward contract is called interest-rate parity.

This extremely important relationship says that a manager, after hedging in the forward exchange-rate market, will realize the same domestic return whether investing domestically or in a foreign country. The arbitrage process that forces interest-rate parity is called covered interest arbitrage.

It can be demonstrated that the forward exchange rate between an investor’s home currency, denoted H and the currency of country i, is equal to

images

where

FH,i = forward exchange rate between investor’s home currency and the currency of country i

        = spot (or cash) exchange rate between investor’s home currency and the currency of country i

   cH = short-term interest rate in the home country which matches the maturity of the forward contract

     ci = short-term interest rate in country i which matches the maturity of the forward contract

cH and ci are called the cash rate. The cash rate is generally the Eurodeposit rate (i.e., offshore deposit rate) for funds deposited in that currency which matches the maturity of the forward contract. Euro deposit rates are available for U.S. dollars and most other major currencies, including for euro-denominated deposits.

By rearranging the above terms in Eq. (53–2), the forward exchange rate discount or premium (or the percentage change of the forward rate from the spot exchange rate), denoted by fH,i, approximately equals the differential between the short-term interest rates of the two countries. That is16

images

That is, for the return on cash deposits to be equal in both currencies, the lower-interest-rate currency must appreciate to the forward foreign exchange rate.

The forward rate can also be expressed in “points” or the difference between the forward and spot rate FH,iSH,i. When interest rates are lower in the foreign country (i.e., the forward points are positive), the forward foreign exchange rate trades at a premium.

The Currency Hedge Decision

If a global bond portfolio is fully hedged, the portfolio return of Eq. (53–1) changes. Specifically, if the manager hedged the currency exposure in all countries using currency forward contracts, the total return for a fully hedged portfolio into the home currency can be expressed as follows:

Total expected portfolio return fully hedged into investor’s home currency

images

where fH,i is the forward exchange-rate discount or premium between the home currency and country i’s local currency. That is, instead of being exposed to some expected percentage change of the home currency to country i’s currency, the manager will have locked in the percentage change of the forward exchange rate from the spot exchange rate (the forward discount/premium) at the time of the hedge.

What will determine whether or not the manager will hedge the exposure to a given country’s exchange rate using a currency forward contract? The decision is based on the expected return from holding the foreign currency relative to the forward premium or discount. That is, if the manager has a high level of conviction that the percentage return from exposure to a currency is greater than the forward discount or premium, then the manager will not use a forward contract to hedge the exposure to that currency.

Conversely, if the manager has a high level of conviction that the currency return will be less than the forward discount or premium, the manager will use a forward contract to hedge the exposure to a currency.

In a case in which the manager believes that the percentage return from exposure to a currency will be greater than the forward discount or premium, the unhedged return for country i can be expressed as

images

In a case in which the manager believes the currency return will be less than the forward discount or premium, we can express the hedged return for a country in terms of the forward exchange rate between the home and local currencies using the interest rate parity relationship. As Eq. (53–3) showed, the forward premium or discount is effectively equal to the short-term interest rate differential; thus

fH,i = cHci

By substituting this relationship into Eq. (53–4) for the forward hedge, the equation for an individual country’s hedged return HR is

Hedged expected return for country images

There remain, however, two further hedging choices for the manager: cross-hedging and proxy hedging.

Cross-Hedging

Cross-hedging is a bit of a misnomer because it does not reduce foreign currency exposure but only replaces the currency exposure to country i’s currency with currency exposure to country j’s currency.

For example, suppose a U.S. manager has an unwanted currency exposure in country i that arose from an attractive bond investment in country i. Rather than hedging with a forward contract between U.S. dollars and the currency of country i and eliminating the foreign currency exposure, the manager elects to swap exposure in country i’s currency for exposure to country j’s currency.

This is accomplished by entering into a forward contract that delivers the currency of country j in exchange for the unwanted currency exposure of country i. The manager might undertake a cross-hedge if there is an expectation of weakening in the home currency, coupled with the view that country j’s currency will outperform country i’s.

When there is a cross-hedge, the hedged return for country i, HRH,i, in Eq. (53–6) can be rewritten as follows:

Cross-hedged expected return for country i, CRH,i = ri + fj,i + eH,j

where fj,i is the forward discount or premium between country j and country i.

This expression says that the cross-hedged return for country i depends on:

1. the expected bond return for country i

2. the currency return locked in by the cross-hedge between country j and country i

3. the currency return between the home currency and country j

We can rewrite the preceding equation in terms of short-term interest-rates as given by interest-rate parity. That is, for fj,i, we substitute cjci. Doing so and rearranging terms gives

Cross-hedged expected return for country i, images

Equation (53–7) says that the cross-hedged expected return for country i depends on:

1. the differential between country i’s bond return and country i’s short-term interest rate

2. the short-term interest rate in country j

3. the currency return between the home currency and currency j

Proxy Hedging

Proxy hedging keeps the currency exposure in country i, but creates a hedge by establishing a short position in country j’s currency. Why would a manager want to undertake a proxy hedge?

This strategy would normally be considered only where the currencies of country i and country j are highly correlated, and the hedge costs in country j are lower than in country i. A proxy hedge also can represent a bullish view on the home currency, with a more negative view on country j’s currency than country i’s currency.

When there is a proxy hedge, the hedged return for country i, HRH,i, in Eq.(53–6) can be rewritten as follows:

Proxy-hedged expected return for country i, PRH,i = ri + eH,i + fH,jeH,j

where fH,j is the forward discount or premium between the home country and country j.

Notice that in this equation there is still the exposure to the exchange rate between the home currency and currency i. The proxy hedge comes into play by the shorting of the currency return between the home currency and currency j.

Based on interest-rate parity, we can replace fH,j with the difference in short-term interest rates, cHcj, to get

   Proxy-hedged expected return for country i, PRH,iri + eH,i + cHcjeH,j

This is equivalent to (adding and subtracting the country i short interest rate ci):

Proxy-hedged expected return for country i,

images

Equation (53–8) states the expected return for country i using proxy hedging depends on:

1. the differential between the bond return for country i and the short-term interest rate for country i

2. the short-term interest rate for country i adjusted for the currency return for country i relative to the home currency

3. the differential in the short-term interest rates between the home currency and country j adjusted for the short currency position in country j

Recasting Relationships in Terms of Short-Term Interest Rates

When we substituted short-term interest-rate differentials for the forward premia or discounts earlier, it becomes apparent from Eqs. (53–6), (53–7), and (53–8) that the difference in return among hedging, cross-hedging, and proxy hedging is entirely due to differences in short-term interest rates and currency exposure. This is also true for the unhedged return for a country, as given by Eq. (53–5). This can be seen by simply rewriting Eq. (53–5) as follows:

  Unhedged expected return for country i, RH,i = (rici)+(ci+eH,i)

The unhedged expected return is thus equal to:

1. The differential between the bond return in country i and the short-term interest rate in country i

2. The short-term interest rate in country i adjusted for the currency return

These equations show how integral the short-term interest-rate differential is to the currency hedge decision. This means that:

1. The short-term interest-rate differential should relate to the currency decision

2. Bond market returns should be calculated as an excess return, that is, less the local short-term interest rate

This can be made explicit by adding and subtracting the home currency short-term interest rate to the four return relationships—unhedged, hedged, cross-hedged, and proxy-hedged. By doing so, this allows the forward premium fH,i = cHci to be inserted into the currency term, giving

Unhedged expected return for country i,

images

Hedged expected return for country i,

images

Cross-hedged expected return for country i,

images

Proxy-hedged expected return for country i,

images

From Eqs. (53–9) through (53–12), we see the return for each strategy can be divided into three distinct return components:

Component 1. The short-term interest rate for the home currency (cH)

Component 2. The excess bond return of country i over the short-term interest rate of country i (rici)

Component 3. The excess currency return, unhedged, cross-hedged, or proxy-hedged

The first two components, cH and rici, are the same for each strategy. The excess currency return (the third component) is the currency return in excess of the forward premium (or discount) and forms the basis of the currency hedging decision. (We will illustrate this below.) The bond purchase decision is purely a matter of selecting those markets which offer the best expected excess return (rici) and the bond and currency allocation decisions are entirely independent.

In a sense, the hedged expected return can be considered the base expected return because it is a component of the unhedged, cross-hedged, and proxy-hedged expected returns. Thus the excess currency returns in the third component are assessed to see if they can add any value over the baseline hedged expected return. This method of analyzing sources of return, in effect, treats bond and currency returns as if they were synthetic futures or forward positions.

It is important to note that only the hedged position eliminates all currency risk, and the only position that has a known return over the investment horizon. The cross-hedge substitutes one currency exposure for another but maintains foreign currency exposure. The proxy hedge leaves the portfolio exposed to “basis” risk if the proxy hedge currency appreciates relative to the investment currency.

Adjusting Bond Yields for Coupon Payment Frequency

In the United States and most other dollar bloc countries, coupon payments are made semiannually. There are other markets that follow this practice. Computing the yield for a semiannual-pay bond can be accomplished using two steps. First, the semiannual interest rate that will make the present value of the semiannual cash-flows equal to the price plus accrued interest is determined. Second, since the interest rate is semiannual, it is annualized by multiplying by 2. The resulting annualized yield is referred to as a bond-equivalent yield.

In European markets (except for the United Kingdom and Italy), coupon payments are made annually rather than semiannually. Thus, the yield is simply the interest rate that makes the present value of the cash-flows equal to the price plus accrued interest. No annualizing is necessary.

The yield quoted in terms of the home market’s convention for payments is called the conventional yield. In countries where coupon payments are made annually (in Germany, for example), the conventional yield is simply the annual yield.

Despite the limitations of yield measures, managers compare yields across market sectors and between countries. Holding aside the problem of potential changes in exchange rates, yield comparisons begin by adjusting conventional yield (i.e., the yield as quoted in the home market) to be consistent with the way the yield is computed for another country.

For example, a French government bond pays interest annually, while a U.S. government bond pays interest semiannually. If the U.S. government bond yield is being compared to a French government bond yield, either (1) the U.S. government bond yield should be adjusted to the yield on an annual-pay basis, or (2) the French government bond yield should be adjusted to a yield on a bond-equivalent yield basis.

The adjustment is done as follows: Given the yield on an annual-pay basis, its bond-equivalent yield (i.e., a yield computed for a semiannual-pay bond) is computed as follows:

Bond-equivalent yield of an annual-pay bond
= 2[(1 + yield on annual-pay bond)0.5 – 1]

For example, suppose that the conventional yield on a French government bond is 4.55%. The bond-equivalent yield is then 4.50%:

2[(1 + 0.0455)0.5 – 1] = 0.0450 = 4.50%

Notice that the bond-equivalent yield of an annual-pay bond is less than that of the conventional yield.

To adjust the bond-equivalent yield of a semiannual-pay bond to that of an annual-pay basis so that it can be compared to the yield on an annual-pay bond, the following formula can be used:

Yield on an annual basis of a bond-equivalent yield
= (1 + bond-equivalent yield/2)2 – 1

For example, suppose that the conventional yield of a U.S. government bond is 4.20%. The yield on an annual-pay basis is

(1 + 0.0420/2)2 –1 = 0.0424 = 4.24%

Notice that the yield on an annual-pay basis will be greater than the conventional yield. Yield spreads are typically computed between the yield of a particular bond and that of a benchmark. The U.S. Treasury yield-curve and the Euro swap market are the two most common benchmarks used.

Forward Rates and Break-Even Analysis

As explained earlier, there are various methods of evaluating relative value in international bond markets. Before these can be translated into a market allocation, a manager must compare their strategic outlook to that which is already priced into the market. This can be accomplished by either converting the economic outlook into point forecasts for bond and currency levels or looking at the forward rates implied by current market conditions and comparing them with the economic outlook.

Bond and currency break-even rates, the rate at which two investments produce identical total returns, are usually calculated versus a benchmark market return over a specific time horizon. A large yield spread between two markets implies a larger “cushion” (the required spread widening to equate total returns in both markets or the break-even rate) over the investment time horizon.

Comparing forward interest rates can be instrumental in identifying where differences between the strategic outlook and market prices may present investment opportunities. Forward interest rates use the shape of the yield-curve to calculate implied forward bond rates and allow a quick comparison of what is required, in terms of yield shifts in each market, to provide a return equal to the short-term risk-free rate (a zero excess return). This would correspond to a bond excess return of zero in Eqs. (53–9) through (53–12), or (rici = 0.

Forward interest rates represent a break-even rate not across markets but within markets. The strategic bond allocation then can be derived by increasing exposure to markets in which the expected bond return over the short-term interest rate is most positive—that is, in which the expected bond yield is furthest below the forward yield. Forward rate calculators are available on systems such as Bloomberg.

The forward foreign exchange rate represents a break-even rate between hedged and unhedged currency returns, as shown previously in the components of return analysis. In terms of Eqs. (53–9), (53–11), and (53–12), currency excess return is zero when the percentage change in the currency equals the forward premium or discount. Since forward foreign exchange rates are determined by short-term interest-rate differentials, they can be estimated from the interest rates on deposits, specifically, Euro deposit rates, as in Eqs. (53–2) and (53–3), which can be obtained easily from market data services such as Bloomberg and Reuters.

Break-even analysis provides another tool for estimating relative value between markets. Because the prices of benchmark bonds are influenced by coupon effects and changes in the benchmark, many international fixed income traders and portfolio managers find it easier to keep pace with changes in yield relationships than price changes in each market. A constant spread between markets when yield levels are shifting, however, may result in a variation in returns as differing benchmark bond maturities and coupons result in a wide spread of interest rate sensitivity across markets. Thus market duration must be taken into account when determining break-even spread movements.

To illustrate this and show how break-even analysis is used, the yield spread between the 10-year U.S. and Japanese government bonds on December 3, 2002 was 322 basis points, providing Japanese investors who purchased the U.S. benchmark Treasury with additional yield income of 80 basis points per quarter. This additional yield advantage, however, can be eliminated by the spread widening substantially less than the 80 basis points. The widening can occur in one of the following two ways:

• Yields in Japan can decrease, resulting in price appreciation of the Japanese government bond

• Yields in the United States can increase, resulting in a price decline of the U.S. Treasury bond

Of course, a combination of the two also can occur. To quantify the amount of spread widening that would erase the yield advantage from investing in a higher yielding market, we need to conduct a break-even analysis.

It is important to note this break-even analysis is not a total-return analysis; it applies only to bond returns in local currency and ignores currency movements. This break-even analysis is effective in comparing bond markets that share a common currency, as within the Euro zone; however, currency must be taken into account when applying break-even analysis to markets with different currencies.

The additional yield advantage in the preceding example is erased if the U.S. dollar depreciates by more than 0.80% during the quarter. Below we illustrate how a hedged break-even analysis can be calculated using hedged returns or simply the forward foreign exchange premium or discount between the two currencies.

The duration of the Japanese bond at the time of this analysis was 9.4. This means that for a 100 basis point change in yield, the approximate percentage price change for the Japanese bond would be 9.4%. For a 50-basis-point change in yield, the percentage price change for the Japanese bond would change by approximately 4.7%. We can generalize this as follows:

Change in price = 9.4 × change in yield

If we let W denote the spread widening, we can rewrite the preceding equation as

Change in price = 9.4 × W

We want to determine the amount of yield movement in Japan that would exactly offset the yield advantage of 0.80% from investing in U.S. bonds. Thus we need to calculate what decline in Japanese bond yields would generate exactly 0.80% in price appreciation to make the Japanese investor indifferent between the two investments (ignoring any potential currency movements).

Thus the equation becomes

0.80% = 9.4 × W

Solving for W,

W = 0.80%/9.4 = 0.085% = 8.5 basis points

Therefore, a spread widening of 8.5 basis points due to a decline in the yield in Japan would negate the additional yield from buying the U.S. Treasury issue. In other words, a change in yields of only 8.5 basis points is needed in this case to negate the three-month yield advantage of 80 basis points.

We refer to this yield spread change as the break-even spread movement. Note that the break-even spread movement must (1) be related to an investment horizon and (2) use the higher of the two countries’ modified durations. Using the highest modified duration provides the minimum spread movement that would offset the additional yield from investing in a higher-yielding market.

Thus, in our example, the three-month break-even spread movement due to Japanese yields is 8.5 basis points, meaning that it is the spread movement due to a drop in Japanese rates by 8.5 basis points that would eliminate the three-month additional yield from investing in U.S. Treasury bonds. The break-even spread movement using the 8.1 duration in the U.S. would have been 9.9 basis points (0.8/8.1 = 9.9); a difference of only 1.4 basis points.

The break-even spread movement just described completely ignores the effect of currency movements on returns. It also ignores the implied appreciation or depreciation of the currency reflected in the forward premium or discount. If we subscribe to the methodology of attributing cash returns to the currency decision and measuring bond market returns as the local return minus the cash rate, the results of the break-even spread movement analysis on a hedged basis may be quite different.

We can easily calculate the hedged break-even spread movement by adding in the forward foreign exchange discount or premium. At the time of this breakeven analysis, three-month interest rates were 0.0675% in Japan and 1.425% in the United States.

With this information, we can obtain the embedded forward rate using Eq. (53-3); that is,

f¥,$ = c¥c$ = (0.0675% – 1.425%)/4 = – 0.34%

The expected hedged return over the three-month period, assuming no change in rates, is the sum of the nominal spread differential (0.80%) and the forward premium (–0.34%), or 0.46%. Thus the break-even spread movement on a hedged basis is a mere five basis points (0.46% = 9.4 × W) instead of the 8.5 basis points of potential widening calculated on a local currency basis.

Consequently, a Japanese investor would have to expect either that spreads would not widen by more than five basis points or believe that the dollar would depreciate versus the yen by less than the embedded forward rate to make the trade attractive. Because currency hedge costs (i.e., the forward premium or discount) are determined by short-term interest rates, the break-even spread movement on a hedged basis always will be smaller when hedging a currency with higher short-term interest rates.

Alternatively, we could use Eq. (53–10) to calculate the expected hedged return to a yen-based investor over a three-month period and compare it to the return on a Japanese 10-year bond over the same period. In order to do so, it is first necessary to adjust the U.S. government bond yield (which is quoted on a bond-equivalent yield basis) to an annual-pay yield basis because the Japanese yield is based on an annual basis. The conventional yield of 4.20% for the U.S. government bond was 4.24% on an annual-pay basis. Assuming no change in rates, the expected hedged return is

[(r$c$) + c¥]/4 = [(4.24% – 1.43%) + 0.07%]/4 = (2.88%)/4 = 0.72%

and the expected Japanese bond return is (1.02%/4, or 0.26%).

Thus the expected return on a hedged basis is 0.44%, which is close to the 0.46% in the first answer that we calculated.

Sector and Security Selection

Once the bond market allocation decisions have been made and the optimal currency, duration, and yield-curve profile selected for each market, the actual portfolio needs to be constructed through the purchase or sale of individual securities. Many international bond investors prefer to trade only benchmark issues because they are more liquid than other similar-maturity bonds. This can sometimes lead to a “hump” in the yield-curve as investors prefer a certain issue or maturity sector. The same phenomenon can result from a squeeze of certain issues in the repo market or short-term demand imbalances for bonds deliverable into short bond futures positions.

Sector selection involves choosing a certain asset class within the fixed income universe that may be undervalued relative to other opportunities. For example, a portfolio manager looking at opportunities in the United Kingdom may favor domestic corporate bonds over government issued gilts. Such a view need not be confined to just one country however. The same investor, for example, who believes corporate bonds in the United Kingdom look more attractive compared with those issued in Italy may overweight the former versus the latter. Identifying these opportunities requires a thorough analysis of relative sector specific dynamics such as the impact of interest rates, growth prospects and other idiosyncratic risks. Moreover, this sector expertise needs to be translated across regions.

Security selection is yet another source of potential return in a global bond portfolio and necessitates a comprehensive credit research team. This team should be able to dissect credit securities across countries and financial markets. Assembling such a team with deep knowledge of local market conditions and factors affecting credit quality is in itself a significant endeavor. However, portfolio managers who have access to such a bench of credit analysts could generate returns above and beyond those managers focused only on active currency, interest rates, and sectors management.

As an example, a portfolio manager could choose to overweight certain industry groups, such as financial institutions, within a specific country. For example, as a result of global credit research recommendations and perspectives, the portfolio manager may favor certain financial companies in Japan over similar institutions in the United Kingdom. By overweighting the debt of these specific Japanese financial institutions, the portfolio manager potentially can attain better returns. Such a strategy once again requires robust risk management systems to minimize idiosyncratic risk; however, achieving these incremental gains can boost the overall performance of the portfolio’s return, particularly in an environment in which rates and/or currencies are range bound.

Similarly, a portfolio manager with a view that gross domestic product (GDP) will grow faster in Japan versus Germany may favor the debt of a consumer goods companies in the former rather than the latter. Consistent with this view, the portfolio manager may choose to make an outright purchase of debt issued by a specific Japanese consumer goods company. Another potential approach would be to overweight the debt issued by the Japanese consumer goods company while underweighting the debt of the German consumer goods company. A portfolio manager with a greater risk appetite and strong conviction with regard to his team’s views may even choose to outright sell the debt issued by the German consumer goods company.

Taxation issues also need to be taken into account when selecting individual bonds for purchase. For example, some markets have tax systems that encourage investors to hold lower-coupon bonds; hence, certain bonds will tend to trade rich or cheap to the curve depending on their coupon. In markets that impose withholding taxes on coupon payments, international fixed income portfolio managers often minimize their tax liability by replacing a bond that is near its coupon date with another bond of similar maturity. Market anomalies also can arise from differing tax treatment within markets.

Hence, international bond portfolio managers have many avenues to generate return, including active currency and interest rate management as well as sector-specific investments. Moreover, with the assistance of a strong global research team, these portfolio managers also may be able to identify specific industry sectors or specific issuers that may increase portfolio returns. Given the breadth of the global fixed income universe, all of these asset allocations can be made relative to interest rate, sector, and security-specific opportunities in other countries. At the same time, while international bond portfolio managers have many potential opportunities to generate returns, they do face many more risks than domestic bond managers. To successfully navigate the international bond market, these portfolio managers need to develop a strong risk management framework and embrace a disciplined investment strategy that can be employed on a global basis.

KEY POINTS

• Global bond exposure, a growing segment of overall portfolio asset allocation, is for both return and diversification purposes.

• Investment policy statements should address allowable investments, including the countries in the investment universe, the securities permitted for portfolio inclusion, the currency benchmark position and risk limits, the time horizon, and the use of derivatives.

• Benchmark selection for an international bond portfolio has many ramifications and should be done carefully because it provides both the return objective and the measure of portfolio risk.

• Investing internationally naturally generates foreign currency exposures that can be managed either passively or actively based on risk guidelines and return objectives.

• Using a 50% hedged portfolio generally offers a compromise in that its return is virtually midway between the return of the unhedged non-U.S. WGBI and the U.S. bond component with substantially lower volatility than the unhedged index, giving it a higher Sharpe ratio than the unhedged index.

• International bond managers also use one or more different management styles, which generally can be divided into four general categories: the experienced trader, the fundamentalist, the black box, and the chartist.

• Excess returns in international bond portfolios are driven by a combination of five broad strategies: currency selection, duration management/yield-curve plays, bond market selection, sector/credit/security selection, and out of benchmark investments.

• Factors such as economic growth, monetary policy, fiscal policy, and politics all play a role in making the strategic asset allocation decisions in a fundamental-based approach to international bond management.

• Other tools used to identify attractive investment opportunities include measures such as real yields, technical analysis, and market sentiment surveys.

• The expected total return of an unhedged international bond portfolio in terms of the home currency depends on three factors: the weight of each country’s bonds in the overall portfolio, the expected bond market return for each country in local currency, and the expected exchange-rate percentage change between the home currency and the local currency.

• In a hedged international bond portfolio, the expected portfolio return is changed to the extent the manager alters currency exposures using instruments such as currency forward contracts relative to the country distribution of the underlying bond exposures.

• Other hedging choices for the manager include cross-hedging and proxy hedging.

• The difference in return between hedging, cross-hedging, and proxy hedging is entirely due to differences in short-term interest rates and currency exposure.

• Bond and currency break-even rates, the rate at which two investments produce identical total returns, are usually calculated versus a benchmark market return over a specific time horizon.

• Comparing of forward interest rates can be instrumental in identifying where differences between the strategic outlook and market prices may present investment opportunities.

• Once the bond market allocation decisions have been made and the optimal duration and yield-curve profile selected for each market, the overall portfolio structure needs to be constructed through the purchase or sale of individual securities which are in or out of benchmark.

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