Overview: Global Bond Management II William L. Nemerever, CFA Managing Director Grantham, Mayo, Van Otterloo & Company L...
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Overview: Global Bond Management II William L. Nemerever, CFA Managing Director Grantham, Mayo, Van Otterloo & Company LLC A tremendous amount has changed in the markets since AIMR’s Global Bond Management conference of 19971—and not all for the better. We have experienced a convergence of the European bond and currency markets, the launching of the European Monetary Union (EMU), and a reduction in the global fixedincome opportunity set, partly because of the shrinking of some major government bond markets—in particular, the U.S. and Australian markets. Significant growth in asset securitizations around the world, not solely in the United States, has also occurred. In 1997 and 1998, the markets were shaken by two tumultuous events that reverberated throughout the global financial world—respectively, the Russian and Asian emerging debt and currency crises. These crises resulted in substantial periods of illiquidity for many investment portfolios. And an unfortunate result has been the paucity of current interest in global fixedincome mandates. For example, Investment Management Weekly listed the investment management searches in the third quarter of 1999 as follows: 124 domestic equity searches, 46 international equity searches, 32 domestic fixed-income searches, 1 global fixed-income search, and no emerging market fixedincome searches. But how can a fixed-income manager operating today not adopt a global outlook? The distinctions among domestic, foreign, and international and among developed, developing, and emerging have blurred significantly. Whereas once the classification of companies, countries, and markets was obvious, today it is difficult. Where should we put Greece, for example, or Poland, or China, or any other investment-grade countries that are emerging? The distinction between high-yield and emerging markets is further confused by high-yield managers tacitly buying emerging debt. This environment is fraught with confusion for all participants—consultants, clients, issuers, and managers—and has created mandates, called “strategic” or “core-plus,” that muddy the waters of performance measurement and asset allocation. How should managers use these additional asset classes— emerging debt, U.S. high yield, foreign bonds, and 1
Global Bond Management, edited by Jan R. Squires (Charlottesville, VA: AIMR, 1997).
currencies? One response is to give a strategic manager the responsibility of making the correct selection and timing decisions regarding the out-of-index asset classes. Often, however, the client retains the Lehman Brothers U.S. Aggregate Index as the manager’s benchmark, opening the floodgates to a multitude of innovative assets that become fodder for inclusion in fixed-income portfolios. No wonder consultants and sponsors are puzzled about the role of fixed-income instruments in global portfolios and a proper modern characterization of global asset classes. The idea of one-stop shopping for investment management is appealing, but it raises the issue of how a single manager or firm can be effective in so many disparate areas. These conflicts have led, of course, to new benchmarks and the development of new indexes. These new performance standards may incorporate emerging market debt, high-yield instruments, and currency. The quest for accurate benchmarks and global indexes, however, is an ongoing process, although progress is being made on several fronts. In addition to the portfolio management implications of many new asset classes, existing local markets are increasingly efficient. These markets give little away to the average investor. Outperformance in efficient environments is not easy. Those of us with some gray hair think fondly back to the 1970s and 1980s, when it was much easier to identify and exploit inefficiencies in local markets. In the developed countries in the late 1990s, the likelihood of finding any significant inefficiencies has all but disappeared. As investment managers and advisors, we believe we can add value to our clients’ portfolios, but the actual accomplishment of this outperformance is not a simple task. Thus, these presentations focus on ways in which we can increase our chances of adding value. The discussions range from the pros and cons of foreign bonds as a strategic asset to the risks and benefits of adding currency exposure in a global portfolio. Another area addressed is sovereign credit risk, recently thrust into the forefront as the possibility of sovereign default moved into the realm of reality. Finally, two speakers examine new indexes recently developed or still under development that incorporate new markets and new instruments. All of these topics are central to finding and adding value in global fixed-income portfolios.
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Global Bond Management II
Are Foreign Bonds a Strategic Asset?
hedged foreign bonds used strategically will reward investors with lower volatility of returns.
This debate centers on the strengths and weaknesses of classifying foreign (nondomestic) bonds as a strategic asset class in a global portfolio. Do foreign bonds warrant the position of a separate asset class, or are foreign bonds merely another sector in the fixed-income markets? We are revisiting this issue because after 10 years of (sometimes heated) discussion, agreement on the subject has yet to be reached. In 1990, Burik and Ennis wrote the seminal piece in this debate.2 Their basic conclusion was that foreign bonds are a waste of time when introduced into portfolios as a separate asset class. In 1991, a spirited rebuttal was led by Filatov, Murphy, Rappoport, and Church.3 In my opinion, Burik and Ennis made the stronger argument. Supporting the view of Burik and Ennis is Michael Rosenberg, who argues that foreign bonds should not be considered a strategic asset because the benefits of passive international diversification to a fixed-income portfolio are limited and added value from international diversification can be achieved only under certain circumstances. One obstacle to a foreign fixed-income allocation is that foreign bonds generally cannot compete with foreign equities, which provide similar diversification benefits but with greater return. Hedging, as a means to control the risk and improve the return of foreign bonds, is not supportable in Rosenberg’s view because the cost is prohibitive for the amount of return per unit of risk reduction. Rosenberg does maintain that foreign bonds can add value in global bond portfolios if used as a tactical asset—that is, if done on a selective rather than constant basis. Circumstances do arise when a tactical addition of foreign bonds can add value, but these favorable circumstances are not the status quo. Countering this viewpoint, Lee Thomas argues that hedged foreign bonds are effective in lowering the total volatility of a global portfolio and thus deserve recognition as a strategic asset. As a rule, he believes, currency hedging is indeed mandatory because the currency component of the foreign bond investment introduces a new and distinct asset class into the portfolio—an asset class that brings with it additional and uncompensated volatility. In Thomas’s opinion,
Risk and Return in Currency Exposure
2 Paul Burik and Richard M. Ennis, “Foreign Bonds in Diversified Portfolios: A Limited Advantage,” Financial Analysts Journal (March/April 1990):31–40. 3 Victor S. Filatov, Kevin M. Murphy, Peter M. Rappoport, and Russell Church, “Foreign Bonds in Diversified Portfolios: A Significant Advantage,” Financial Analysts Journal (July/August 1991):26–31.
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Probably the most efficient market in the world is the currency market. Thus, potential is extremely limited for managers to add value through currency alone. Moreover, much confusion exists about the issue of currency exposure. Evaluating a manager’s skill at currency hedging is extremely difficult, and the investor should be aware of several biases in the performance reporting of currency managers. In addition, no truly homogeneous universe of currency managers exists, nor does a really uniform currency benchmark. Nevertheless, although the intricacies of currency management are many, currency is an interesting and potentially valuable source of global alpha. Ronald Layard-Liesching provides a concise synopsis of the structure of global currency markets and the sources of risk and return in global bonds from a currency-related perspective. Layard-Liesching calls our attention to the high time concentration of returns unique to the currency markets. These episodic return patterns have correspondingly serious implications for currency risk management. Layard-Liesching also points out the difference between an investment and an exposure. Because no net capital investment is represented in creating the currency component of a portfolio, no excess return should be expected. Yet despite no provision of excess return, currency exposure does introduce additional risk. Layard-Liesching concludes that fundamental forecasting models have not been successful in determining trends in currency movements but that some roads in the quest for dependable currency forecasting models appear promising. In the meantime, the tools to measure currency risk are available and viable. Thus, until foreign exchange trends can be reliably forecasted, the only practical way to approach currency is to actively manage the risk associated with it so as to enhance the risk-adjusted returns of the global fixed-income portfolio.
Improving Sovereign Risk Analysis One area that may yet offer opportunities to find inefficiently priced instruments is sovereign credit analysis. The assessment of the likelihood of sovereign debt defaults is a fascinating topic, but until recently, it was fascinating primarily to academics. In 1998 and 1999, however, sovereign default claimed the attention of the financial community through two very real events. First, the Russian Federation (or the former Soviet Union, depending on which debt you
©2000, Association for Investment Management and Research
Overview are considering) defaulted on its government debt. Soon thereafter, the first default on a Brady bond occurred, in Ecuador. As global changes affect internal and external sovereign relationships, the ability to forecast defaults gains importance while the analytical process grows in difficulty. David Anthony points out that conducting sovereign debt assessment with nothing more than the tools of corporate credit analysis seriously understates the complexity of the task. Anthony discusses the changes in sovereign debt risk analysis and reporting mandated by the almost overwhelming forces of globalization and privatization. Constant change in sovereign relationships and within sovereign economies is mandating a complementary shift in the tools and assumptions of sovereign debt risk analysis. Not only does the concept of default vary among governments, but the factors that contribute to the default equation vary as well. So, although the ability to forecast default is truly a challenge for the analyst, the risk assessment process generates substantial value if undertaken properly. Anthony describes six specific areas identified by the Economist Intelligence Unit that have spurred sovereign internal and external realignments during the past two decades. He goes on to recommend responsive alterations in the analytical and reporting processes for each of these areas, and he encourages the use of quantitative parameters as an objective analytical tool. Anthony concludes that the future reporting of sovereign debt risk analysis will be more frequent, shorter, and contain more analysis than simple reporting. He expects greater cross-country comparisons within the context of regional, historical, and global events. Even with these improvements in reporting and analysis, however, the analyst will have a serious challenge in accurately forecasting sovereign default.
Benchmarks New mandates—out-of-benchmark mandates—are now a regular occurrence in the investment management community. When a benchmark varies substantially from an investment portfolio, however, consultants, clients, and managers are often confused about how to measure performance and what the performance measurement actually means. The asset allocation framework is also affected as managers sort through the widening opportunity set to construct a fixed-income portfolio. The broadening mandates have thus prompted the search for indexes that can serve as representative benchmarks for various opportunity sets of fixed-income instruments. Historically, as additional asset classes have appeared, indexes have kept pace. For example, the Lehman
Government/Corporate Index of the 1980s evolved into the Lehman Aggregate Index we know today. Another issue of concern with global indexes is the weighting of the index components. Marketcapitalization weighting is the obvious way to weight an index because this methodology mirrors the actual country market pool available to investors. Two authors, one from Lehman Brothers and one from J.P. Morgan, speak on behalf of cap weighting. As they point out, opening up the indexes to other weighting methods introduces the element of artificiality. Nevertheless, Morgan has introduced an index that uses a different weighting scheme. Also at issue in the development of moreinclusive indexes is the degree to which clients, consultants, and managers will accept the behavior of an index that incorporates the characteristics of riskier assets. As riskier assets are added to less risky assets, the index becomes susceptible to massive drawdowns. The authors also address these issues as they describe the new global and emerging market indexes. As Lev Dynkin points out, Lehman Brothers is constantly working on broadening the Lehman family of fixed-income indexes. Dynkin describes the reasoning behind the creation of global opportunity sets and the process Lehman followed to create two new macro indexes. One of these indexes, the U.S.-DollarDenominated Universal, is complete and is currently in use. The U.S. Universal is a combination of all Lehman’s U.S.-dollar-denominated fixed-income indexes. Compared with the Lehman U.S. Aggregate, the U.S. Universal exhibits many positive attributes: greater diversification in credit quality, higher returns, a lower standard deviation of return, and less empirical sensitivity. The second macro index, the Global Aggregate, is in the pipeline. The major component of the Global Aggregate that has not yet been created is the Asian Aggregate. The Global Aggregate will represent the entire U.S. and non-U.S. fixedincome opportunity set. The exact properties of the index are unknown at this time, but the informational content of the index will be quite valuable, even if the benchmark attributes are not optimal. Peter Rappoport explains the emerging market indexes that have been developed by J.P. Morgan, which build on the currently popular Emerging Markets Bond Index Plus (EMBI+). One of the new indexes is the Emerging Markets Bond Index Global (EMBI Global), which expands the number of countries and instruments in the EMBI+. Because the Latin American bias in the EMBI+ has been a cause for criticism in the past, Morgan has constructed the EMBI Global to be a market-cap-weighted index that provides more representation in Europe and Africa and less in Latin
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Global Bond Management II America than the EMBI+. The other new index is the EMBI Global Constrained. It is also an expanded version of the EMBI+, but the Global Constrained Index is constructed to limit the face amount of the debt of the larger countries in the index. Thus, it is not strictly a cap-weighted index. The liquidity of the EMBI+, a major advantage of that index, has been largely preserved in both new indexes. Therefore, in the short term, the volatility of the new indexes is expected to be similar to that of the EMBI+. In the long run, however, significant diversification benefits in terms of volatility should be observed.
Summary The quest for alpha in the global fixed-income markets can be pursued through many venues, and alpha
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in the global fixed-income markets can be measured with respect to many different benchmarks. The attraction of emerging markets and innovative asset classes arises from their lack of homogeneity in credits and products, which allows room for the inefficiencies that have been all but removed from the sovereign bond markets of developed countries. All of the vehicles discussed here—currency, sovereign debt, and emerging market instruments—are viable tools for investors, but their use is accompanied by an increase in the likelihood of high-risk events. And as the indexes incorporate these asset classes, they also become riskier benchmarks. The manager must be cognizant of such risks, be prepared to measure and manage the risks, and be able to educate clients as to risk and return expectations.
©2000, Association for Investment Management and Research
Foreign Bonds: Not a Strategic Asset Michael R. Rosenberg Managing Director and Head of Global Foreign Exchange Research Deutsche Bank
Theorists have tried to make a case for adding foreign bonds to a U.S. fixed-income portfolio on the basis of the beneficial effects of, first, unhedged foreign bonds; then, hedged foreign bonds; and recently, high-yield foreign bonds. The only approach that makes sense in light of the historical evidence, however, is for portfolio managers to move in and out of foreign bonds as indicated by market conditions.
he support for international fixed-income diversification has evolved during the past 20 years from trying to make a case for increasing returns and decreasing risk through unhedged foreign bonds (that is, non-U.S. domestic credits denominated in currencies other than the U.S. dollar) to finding the same benefits through hedged foreign bonds to lauding the benefits of such recent strategies as exploiting the forward discount bias. In the early 1980s, when investors were first becoming involved in the international fixed-income market, they were seeking diversification through unhedged international fixed-income assets. During this period, some researchers set out to demonstrate that on an unhedged basis, passive international fixed-income securities can lead to a significant reduction in a portfolio’s overall risk. As analysts and investors obtained more data, however, they began to see that the amount of risk reduction from this source of diversification was actually small. Thus, making a case for international fixed income as a separate asset class passively added to a portfolio became harder and harder. Nevertheless, the analyst and investor communities did not stop trying to salvage the case for foreign bonds. The idea of pursuing currency-hedged foreign bonds for diversification was suggested. At first, currency hedging seemed to offer a “free lunch”: Not only could significant excess return be earned by investing in currency-hedged foreign bonds, but those excess returns could also be achieved with reduced risk. After the initial studies, however, analysts and investors began to discover that if investors wanted to
T
Editor’s note: The joint Question and Answer Session of Michael Rosenberg and Lee Thomas follows Mr. Thomas’s presentation.
reduce portfolio risk, they had to sacrifice something in portfolio return. Hence, the free lunch concept was dispelled and the case for currency-hedged foreign bonds lost allure. The generation of new data in subsequent years prompted portfolio managers to look for other opportunities to use the foreign fixed-income markets. A recent strategy has been to exploit the forward discount bias. Based on historical evidence that high-yield bonds produce excess returns (relative to low-yield bonds) over time, this strategy mandates investment in high-yield bonds. Examining each theory in turn, I present the case against the attractiveness of foreign bonds as a separate asset class to be used in constructing fixedincome portfolios. I do find, however, that foreign bonds have a tactical role to play in bond portfolios.
Unhedged Foreign Bonds I define an asset class as a group of securities with similar characteristics that, when combined in a broadly diversified portfolio, contribute meaningfully to the expected return and/or risk reduction of the entire portfolio. In other words, a group of securities becomes an asset class if they, as a class, contribute something to an otherwise well-diversified portfolio. If the securities do not contribute much to either risk reduction or portfolio return, then they are not worth including, as a class, in a portfolio. The long-run data on foreign bonds versus U.S. domestic bonds seem to support the conclusion that foreign bonds outperform U.S. bonds. Figure 1 shows that unhedged foreign bonds have been the higher-returning asset relative to U.S. bonds in the 1973–99 period.
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Global Bond Management II Figure 1. Total-Return Performance of the Non-U.S. and U.S. Bond Markets, 1973–99 (U.S. dollar terms) 1973 = 100 2,000 1,800 1,600 Non-U.S.
1,400 1,200 1,000 800 600
U.S.
400 200 0 1973
76
79
82
85
88
91
94
97
2000
Note: The U.S. bond market for 1973–1978 is represented by the Merrill Lynch U.S. Government/ Corporate Index and for 1978–1999 by the Merrill Lynch U.S. Government Bond Index. The non-U.S. bond market for 1973–1981 is represented by the InterSec Non-U.S. Dollar Bond Index and for 1981–1999 by the Salomon Brothers Non-U.S. Dollar Government Bond Index.
Sometimes, however, data are misleading. In the long run, unhedged foreign bonds are expected to have the same yield as U.S. bonds. And in fact, they do. The 1973–85 data in Figure 1 illustrate this point. When 1988 is chosen as the start of the index instead of 1973, the result is similar, as Figure 2 shows. Only in the two-year window of 1986–1987, when the U.S. dollar collapsed, did unhedged foreign bonds substantially outperform U.S. bonds, but these two years distort the long-run picture. At least in the last 11–12 years, these returns have had no major divergences. In short, foreign bonds have outperformed U.S. bonds in some periods and underperformed in other periods, but in the long run, the expected return is about the same. Adding unhedged foreign bonds to a passively managed portfolio of U.S. bonds in the 1973-99 period would have improved the portfolio’s overall risk–return trade-off only slightly. In Figure 3, foreign bonds again appear to be the significantly higher-returning asset, but this result is also an artifact of the U.S. dollar collapse in 1986–1987. In reality, the risk–return function for U.S. and foreign bonds is simply a horizontal line; that is, foreign bonds provide an identical return but with much higher risk. Investors have been reluctant to invest in passively managed, unhedged foreign bonds for reasons other than the meager return contribution of the sec-
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tor to a diversified U.S. fixed-income portfolio. Foreign bonds have historically underperformed foreign equities, and because return is a strong inducement for allocation to a particular asset class, foreign bonds simply have not had the edge over foreign equities. Burik and Ennis reported in 1990 the deficient return from adding passively managed foreign bonds to a U.S. portfolio: absent superior active management . . . foreign bonds make only a modest contribution to domestic portfolios that hold domestic fixed income securities and already enjoy efficient international common stock and real estate diversification. Consequently, many investors . . . will conclude that foreign bonds constitute a diversification opportunity they can afford to pass up. 1
In addition, unhedged foreign bonds are highly correlated with unhedged foreign equities, largely because movements in exchange rates heavily influence the U.S.-dollar-adjusted returns from a U.S. investor’s standpoint. Therefore, the new international mandates are in equities, which provide identical diversification benefits but with an asset class that is expected to produce a higher return. 1 Paul
Burik and Richard M. Ennis, “Foreign Bonds in Diversified Portfolios: A Limited Advantage,” Financial Analysts Journal (March/April 1990):32.
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Foreign Bonds: Not a Strategic Asset Figure 2. Total-Return Performance of Foreign and U.S. Bonds, 1988–99 (U.S. dollar terms) 1988 = 100 300
Non-U.S. Bonds
250
200 U.S. Bonds 150
100
50 1988
89
90
91
92
93
94
95
96
97
98
99
2000
Note: U.S. bonds are represented by the Merrill Lynch U.S. Government Bond Index. Non-U.S bonds are represented by the Salomon Brothers Non-U.S. Dollar Government Bond Index.
Figure 3. Risk–Return Profile of Passively Managed Global Fixed-Income Portfolios, 1973–99 Return (%) 11.0
10.5 100% Foreign Bonds
10.0
9.5 20% Foreign/80% U.S. Bonds
9.0 100% U.S. Bonds 8.5 5
6
7
8
9
10
11
12
Risk (standard deviation of return, %) Note: U.S. bonds for 1973–1978 are represented by the Merrill Lynch U.S. Government/Corporate Index and for 1978–1999 by the Merrill Lynch U.S. Government Bond Index. Non-U.S. bonds for 1973–1981 are represented by the InterSec Non-U.S. Dollar Index and for 1981–1999 by the Salomon Brothers NonU.S. Dollar Government Bond Index.
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Global Bond Management II
Hedged Foreign Bonds As it became clear that a case could not be made for unhedged foreign bonds as an attractive asset class, analysts attempted to build a case for hedged foreign bonds. If currency risk could be detached from the fixed-income decision by hedging, one of the biggest sources of volatility in an unhedged portfolio could be removed. If hedging that currency risk did not cost anything in terms of expected return, then hedged foreign bonds would be superior to unhedged foreign bonds at any given level of return. The initial evidence demonstrated that hedged foreign bonds did indeed offer a free lunch. Panel A of Figure 4 shows not only that hedged foreign bonds in 1978–1987 had lower risk than U.S. bonds because currency volatility was removed but that they also yielded a higher average return. This time period was misleading, however, because unique yield-curve slopes allowed U.S. investors to buy foreign bonds and then sell the foreign currency forward at a large premium, which created these excess returns for foreign bonds. The data in the next period, 1988–1995, indicate that the free lunch was beginning to disappear. Panel B of Figure 4 shows that U.S. bonds outperformed hedged foreign bonds in the 1988–95 period. During this period, U.S. bonds were also more volatile than their foreign bond counterpart, largely because foreign bonds reverted to the historical norm of having lower volatility than U.S. bonds. Therefore, to reduce portfolio risk with hedged foreign bonds, an investor had to sacrifice portfolio return. The free lunch vanished. The issue of hedged versus unhedged foreign bonds involves certain key points. Hedged foreign bonds are clearly less volatile than unhedged foreign bonds, but unhedged foreign bonds are better diversifiers. Unhedged foreign bonds in a portfolio allow an investor to capture exchange rate movements. Removing exchange rate movements from the equation increases the correlation between U.S. bonds and foreign bonds because U.S. interest rates and foreign interest rates tend to move together. Most bull and bear markets for the past 10–20 years have been global in scope. The chances of a bull market in one country and a bear market in another are slim. As Table 1 shows, when either monthly or quarterly data are used, correlations are lower between U.S.
Table 1. Correlation of U.S. Bonds with Foreign Bonds With Hedged Foreign Bonds
With Unhedged Foreign Bonds
Monthly
0.54
0.42
Quarterly
0.82
0.62
Data
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Figure 4. Historical Risk–Return Trade-Offs: U.S. Bonds versus Hedged Foreign Bonds A. 1978–1987 Return (%) 11
100% Hedged Foreign Bonds
10 9 8
100% U.S. Bonds
7 6 5
6
7
8
9
10
11
Risk (%)
B. 1988–1995 Return (%) 11 100% U.S. Bonds
10 9
70% Hedged Foreign Bonds/ 30% U.S. Bonds
8
100% Hedged Foreign Bonds
7 6 3
4
5
Risk (%) Note: U.S. bonds are represented by the Merrill Lynch U.S. Government Bond Index. Hedged foreign bonds are represented by the Salomon Brothers Non-U.S. Dollar Hedged Index.
bonds and unhedged foreign bonds than they are between U.S. bonds and hedged foreign bonds. Whether unhedged foreign bonds or hedged foreign bonds are chosen, theoretically, the same level of risk reduction and, for the most part, the same level of return will result. Unhedged foreign bonds are more volatile but should earn the same expected return as U.S. domestic bonds; U.S. domestic bonds and hedged foreign bonds not only should have the same expected return but also should have the same expected volatility. Figure 5 shows this relationship between U.S. domestic bonds and/or hedged foreign bonds and unhedged foreign bonds.
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Foreign Bonds: Not a Strategic Asset Figure 5. Theoretical Diversification Benefits from Combinations of U.S. and Hedged/Unhedged Foreign Bonds Expected Return (%) High
Portfolio of U.S. Domestic and Hedged/Unhedged Foreign Bonds
U.S. Domestic Bonds and/or Hedged Foreign Bonds
Unhedged Foreign Bonds
MinimumRisk Portfolio
Low
High Risk (%)
Note: U.S. bonds are represented by the Merrill Lynch U.S. Government Bond Index. Hedged foreign bonds are represented by the Salomon Brothers Non-U.S. Dollar Hedged Index, and unhedged foreign bonds are represented by the Salomon Brothers Non-U.S. Dollar Government Bond Index.
Based on the preceding observations, I developed Rosenberg’s Proposition #1: In a world free of transaction costs, the amount of risk reduction available from international diversification in the long run is independent of whether the currency risk is hedged or not.
This proposition follows the Modigliani–Miller theorem that a firm’s value is independent of its capital structure. Costs do, however, need to be taken into account. The additional costs associated with managing a hedged rather than an unhedged portfolio amount to about 5 basis points for execution costs, 5 bps for settlement costs, and 10–20 bps for management fees. When the cost of rolling over hedges on a monthly basis is considered, the result is Rosenberg’s Proposition #2: In a world where transaction costs and management fees are not insignificant, hedged foreign bonds will be the more expensive route to achieve risk reduction through international diversification.
A compelling case cannot be made for either unhedged or hedged foreign bonds. From the evidence offered here, the amount of risk reduction each provides is small.
High-Yield versus Low-Yield Foreign Bonds The recent strategy to exploit the forward discount bias hinges on investing in high-yield foreign bonds. Historically, high-yield foreign currency bonds have consistently outperformed low-yield foreign currency bonds. High-yield currencies, generally associated with high-yield bond markets, do not depreciate in line with the relative interest rate differentials between the various country bond markets. Excess return exists because the forward markets price in excess currency weakness for the high-yield markets. Just as corporate bonds yield more than U.S. governments because they are riskier, high-yield currencies offer higher returns in the long run because they are riskier. High-yield bonds are more prone to volatile moves at discrete points in time. That excess returns are created in the long run by investing in high-yield markets is thus not surprising. What could end up being excess returns in the long run, however, could in the short run result in a career-threatening move in exchange rates, which would make any long-run advantage irrelevant.
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Global Bond Management II A number of reasons explain the superior performance of high-yield investments: • When the risk of a particular currency’s collapse is high, the market will require a relatively high yield to reflect this possibility. If no collapse occurs over a given time period, the high-yield currency will appear to have outperformed the low-yield currency. This phenomenon is known as “the peso problem.” Although in the long run the high-yield currency will eventually depreciate, over a particular time horizon no depreciation may occur, thereby making the returns on high-yield currencies seem larger than they really are. • The market may demand a risk premium to hold high-yield currencies. If high-yield currencies are more volatile, they should have more default risk or more potential currency risk. In this case, a premium is built in to capture the tails and the distribution of potential exchange rate movements. • Monetary policy in high-yield-currency countries could be a factor. High-yield currencies tend to be more depreciation prone; therefore, central banks in these countries may keep their rates high for inordinate periods of time to defend their currencies. • Systematic prediction errors could be at fault. That is, the market may systematically continue to overpredict the depreciation of high-yield currencies or overpredict the strength of low-yield currencies. (I find it hard to believe, however, that the market can make systematic prediction errors for long time periods.)
When high-yield markets consistently outperform low-yield markets, the high-yield-currency country faces potentially severe economic consequences. The high-yield currency will become increasingly overvalued from the standpoint of purchasing power parity. Also, if bond yields are high in the high-yield-currency country, real interest rates in the high-yield country are going to be considerably higher than real rates in the low-yield country. Thus, the high-yield country will suffer a loss of competitiveness, a slowdown in economic activity, and increased vulnerability to a currency crisis. In other words, the persistence of excess returns in high-yieldcurrency investments actually increases the country’s vulnerability to an eventual currency collapse, which makes high-yield investments risky ventures. This situation occurred in the case of the Exchange Rate Mechanism currencies in 1992. For a number of years, the high-yield markets, such as Italy, outperformed the low-yield markets, such as Germany. Figure 6 shows this comparative performance for 1987–1999. Numerous global fixed-income funds, thinking this trade was a free lunch, put on a long Italian bond–short German bond trade. Thus, long lira positions were in large part being funded with German marks until the fall of the lira in 1992, which wiped out a number of large global fixedincome funds. In the long run, higher-yielding Italian bonds have outperformed lower-yielding German bonds, providing excess returns over time, but many of the people stung in 1992 by the lira’s collapse may not have been able to hang on long enough to experience the subsequent recovery.
Figure 6. Total-Return Performance of Italian and German Money Market Instruments, 1987–99 (German mark terms) 1987 = 100 260 Italian Instruments 220
German Instruments
180
140
100 1987
88
89
90
91
92
93
94
95
96
97
98
99
2000
Source: Datastream.
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©2000, Association for Investment Management and Research
Foreign Bonds: Not a Strategic Asset The same phenomenon occurs in emerging markets. For example, many investors were caught leaning the wrong way in the Mexican peso trade earlier in this decade. Significant excess returns were earned by going long pesos against the U.S. dollar from 1992 to 1994—until December 1994, when investors were forced to give back in a single day all the returns previously earned by this trade. In summary, high-yield bonds yield more than low-yield bonds because high-yield bonds are riskier. These bonds require a higher yield to induce investors to accept additional risk. And although over the long run high-yield bonds should provide excess returns, a single devastating event—generally not adequately reflected in even the highest of yields— could lead to catastrophic results for the investor.
Foreign Bonds as a Tactical Asset Rather than promoting foreign bonds as a separate strategic asset class, I argue that foreign bonds should be promoted as a subset of the global (domestic and nondomestic) fixed-income asset class. Foreign bonds should be viewed as a tactical asset. Strategic asset allocation determines how much of the portfolio an investor wants allocated to equity, fixed income, cash, real estate, or venture capital. Then, within the fixed-income class, the next step is to decide how much the investor wants to invest in domestic and foreign securities. In the domestic realm, investors must decide how much they want to invest in government bonds, corporate bonds, mortgages, or high-yield bonds. In the realm of foreign bonds, investors then decide whether they want to invest in hedged or unhedged bonds. Tactical asset allocation deviates from the portfolio’s strategic asset allocation to exploit temporary market imbalances with the intention of increasing portfolio return. For example, an investor who has a portfolio invested entirely in U.S. fixed-income assets but allocates a portion of the portfolio to foreign bonds when an opportunity arises in a particular country or sector is practicing tactical asset allocation. To facilitate this process, the investor might set up trading rules like those in Table 2. If the investor is bullish on the U.S. dollar—if the U.S. dollar, say, rises above its 12-month moving average—the investor will be 100 percent invested in U.S. bonds. If the dollar falls below its 12-month average, the investor will invest 80 percent in U.S. bonds and 20 percent in foreign bonds. The rule is that the holder of a U.S.
bond portfolio will never invest more than 20 percent in foreign bonds, but 20 percent can be a sizable bet for a U.S. portfolio.
Table 2. Hypothetical Trading Rules for Allocation to U.S. and Foreign Bonds Bond Type U.S. domestic Foreign Total allocation
Bullish on U.S. Dollars 100%
Bearish on U.S. Dollars 80%
0
20
100%
100%
That simple trading rule would have yielded in the past 20–25 year period an excess return of nearly 175 bps a year over the return of a portfolio invested 100 percent in U.S. fixed-income assets. Figure 7 provides a comparison of the performance of these strategies since 1976. In short, foreign bonds can contribute meaningfully to an otherwise well-diversified U.S. portfolio if they are used tactically by the portfolio managers to enhance the return provided by the strategic assets.
Summary The evidence that foreign bonds constitute a separate strategic asset class that can add value for U.S.-dollarbased investors is not compelling. The case against foreign bonds as a separate asset class can be summarized as follows: • In terms of reducing portfolio risk or enhancing returns, the benefits of passive international diversification are limited. • Foreign bonds offer investors a unique opportunity to enhance return, but that return enhancement can be achieved only through successful active management. This business offers no free lunches. • Foreign bonds are best viewed not as a strategic asset class for all seasons but as a tactical asset for select seasons. In fact, the market has already voted with its pocketbook about whether international bonds are an attractive strategic asset class. Today, few dedicated international fixed-income fund managers operate in the investment management business and even fewer international fixed-income mandates are being awarded to those managers still persevering. Foreign bonds are, on the other hand, a unique tactical asset that U.S. fixed-income managers can successfully incorporate in a broadly diversified portfolio.
©2000, Association for Investment Management and Research
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Global Bond Management II Figure 7. Total-Return Performance of an Actively Managed Global Bond Portfolio versus a 100 Percent U.S. Bond Portfolio, 1976–99 1976 = 100 1,200 1,100 20% Foreign/80% U.S. Bonds
1,000 900 800 700 600 500
100% U.S. Treasury Bonds
400 300 200 100 1976
78
80
82
84
86
88
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92
94
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98
2000
Note: The U.S. bond portfolio for 1976–1978 is represented by the Merrill Lynch U.S. Government/ Corporate Index and for 1978–1999 by the Merrill Lynch U.S. Government Bond Index. The global bond portfolio for 1976-1981 is represented by the InterSec Non-U.S. Dollar Index and for 1981–1999 by the Salomon Brothers Non-U.S. Dollar Government Bond Index.
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©2000, Association for Investment Management and Research
Foreign Bonds
Question and Answer Session Michael R. Rosenberg Lee R. Thomas III Question: Mr. Rosenberg, would following the sample trading rule in your Table 2 have produced excess returns also in the 1973–85 or 1988–99 period? Rosenberg: The sample trading rule was simply an illustration of how a tactical portfolio could be run. I was not trying to recommend those particular moving averages or any type of technical trading rule as the motivation for moving in and out of foreign bonds. Still, following the sample trading rule might have yielded excellent returns for 1973–1987. From 1988 on, it probably would not have been as profitable, largely because exchange rates experienced no big moves comparable to those in the 1970s and 1980s. Levich and Thomas have done some work showing that technical trading rules would have generated significant excess returns through 1990.1 During the 1990s, the returns have not been as strong. Question: Mr. Thomas, what method of estimation did you use to explain the contribution of a foreign market’s volatility to a domestic portfolio? Thomas: The amount of domestic volatility explained by foreign volatility is given by the coefficient of determination (R2). To derive more detail requires more subtle analysis. I like to deconstruct the portfolio to identify the marginal contribution to risk from each of 1 Richard Levich and Lee Thomas, “The Significance of Technical Trading-Rule Profits in the Foreign Exchange Market: A Bootstrap Approach,” NBER Working Paper 3818 (1991).
the components. (The mathematics uses Euler’s equation.) Question: What blend between U.S. and hedged non-U.S. bonds is optimal? Thomas: For a passive U.S. investor who doesn’t believe that foreign bonds have a higher or lower expected return than U.S. bonds, the risk-minimizing mix has historically been close to that of the WGBI, about 30 percent U.S. assets/70 percent foreign assets. Once the United Kingdom, Sweden, and Greece enter the EMU, however, the optimal weights will probably change to something closer to 50/50. Question: After the cost of hedging, are the diversification benefits still significant, and what is the most efficient method for hedging foreign exchange risk? Thomas: Running a hedged portfolio is not always more expensive than running an unhedged portfolio. For example, suppose I am running a globally diversified portfolio and I am implementing the portfolio strategy with futures contracts. That is, I hold U.S. bond futures, German bond futures, and so forth to replicate the global index. That portfolio is already currency hedged, so there are no extra hedging costs. Indeed, in order to unhedge the portfolio, I would have to buy currency, which would add to my transaction costs. The same would be true for a portfolio of swaps. So, whether a cost will be associated with currency hedging depends on how the investor runs the portfolio, including what instruments the investor
©2000, Association for Investment Management and Research
uses and how the investor implements the currency hedges. My company uses a combination of devices—futures and swaps, bond repos, forward foreign exchange contracts—depending on what we’re trying to accomplish and what the prices are in the market at a given time. Question: How does the development of a corporate bond market in Europe and the existence of Yankee bonds affect your conclusions about the attractiveness of foreign bonds as an asset class? Rosenberg: When analysts look at U.S. bonds versus foreign bonds, they are usually looking at U.S. sovereign bonds versus foreign sovereign bonds. The reason U.S. fixed-income managers have only the one international fixed-income mandate (foreign sovereigns) and so many more domestic fixedincome mandates is that if the expected return on foreign sovereigns is the same as on U.S. government bonds, the manager can gain higher returns by diversifying into U.S. corporates, U.S. mortgages, U.S. high-yield bonds, and other domestic assets. U.S. fixed-income managers understand the domestic markets and their risk characteristics. Someone who wants to make a case for foreign bonds must first explain why U.S. investors should be looking at foreign sovereigns rather than U.S. corporates, U.S. mortgages, and so on. U.S. investors do not invest in foreign corporates and foreign high-yield instruments because these markets are not yet fully developed. Today, portfolio managers are limited as to what they can add from those markets. This
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Global Bond Management II situation will obviously change over time. Then, U.S. investors will have to ask themselves how foreign corporate bonds are performing relative to U.S. corporate bonds. Foreign sovereigns provide no excess return relative to U.S. governments, so should we expect any excess return from foreign corporates relative to U.S. corporates? How far down the credit-risk structure will U.S. investors have to move to get higher returns in foreign markets than similar markets in the United States? This issue is going to be the key. Thomas: European markets are changing, and the big story of the next decade will be how U.S. investors can exploit new products, such as corporate bonds, as they develop in Europe. This change may be to the advantage of U.S. investors, who are familiar with using these instruments in the U.S. market. Currently, in Europe, the corporate bond market is substantially an upper-tier market, dominated by issues with ratings of AA or AAA, but recently a junkbond market has developed. And the rest of the credit spectrum will fill in, in part as a result of competition among European bankers.
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Europe has far too many banks. With the EMU in place, competition among European banks is already leading to mergers and acquisitions. Only a handful of banks will emerge as the victors, which is why Deutsche Bank and others are trying to grow so quickly. They want to make sure they are the acquirers. To do so, they must raise their return on equity (ROE). In the past, the European corporate bond market was small because banks made sweetheart loans to their corporate clients to cement their relationships and then made their revenue on other banking fees. As European banks become more ROE focused, they are likely to turn away some corporate clients, and those clients will go to the bond markets to raise funds. Fortunately, European corporate borrowers will hit the bond markets at just the right time. European governments are trying to salvage their bankrupt pension systems by encouraging private pension plans. With little opportunity existing to add alpha from active, top-down, macroeconomic management—a consequence of EMU—investors will be looking for spread products offering higher yields than government bonds. In its early stages, the new European bond market is likely to
have many inefficiencies This will provide an excellent opportunity for U.S. portfolio managers. U.S. expertise in corporate bond management, corporate credit analysis, mortgage-backed securities, assetbacked securities, and so forth, will be needed. U.S. managers are already familiar with these sectors. It promises to be an exciting market. Question: What about the option of using tactical foreign exchange management instead of limiting choices to hedged and unhedged foreign bonds? Rosenberg: I am in favor of tactical foreign exchange management as one more tool in the management process. Currency decisions are critical in the global fixed-income decision process. Many international fixed-income managers would probably say that currency management is a major part of what they do. Some in the industry argue that foreign bonds are simply a vehicle for speculating in the currency markets. Because pension managers are not allowed to allocate money for pure currency speculation, they hire global fixedincome managers who are actually closet currency speculators.
©2000, Association for Investment Management and Research
Foreign Bonds: A Strategic Asset Lee R. Thomas III Managing Director Pacific Investment Management Company
Foreign bonds can be used opportunistically as a tactical asset or strategically as a permanent part of an investor’s asset allocation. The strategic case for foreign bonds, however, can be made only for hedged foreign bonds. The strategic argument for foreign bonds rests on risk reduction: Because world bond markets are not perfectly correlated, the addition of currency-hedged foreign bonds into a domestic bond portfolio will lower portfolio volatility.
ichael Rosenberg presented the case against the attractiveness of foreign bonds as a separate asset class.1 On many points, I agree with him. On others, I disagree. After spelling out these similarities and differences, I will describe exactly how foreign bonds can be used beneficially as a strategic as well as a tactical asset.
M
Points/Counterpoints My approach assumes that the question of whether or not to hedge foreign currency when investing in foreign (that is, nondomestic) bonds has been answered. If investors do not hedge their currency exposure, foreign bonds can produce little risk reduction. Therefore, I focus my argument solely on hedged foreign bonds. Rosenberg and I agree on many of the facts about hedged foreign bonds, but we disagree substantially on the interpretation of those facts. First, from a U.S. bond manager’s standpoint, we agree that non-U.S. bonds are a tactically useful sector within the fixedincome asset class. In the same way a U.S. bond manager might rotate from government bonds into mortgage-backed securities or corporate bonds, the manager might also rotate into foreign bonds to garner prospective alpha for the portfolio. I also agree that the expected returns of foreign bonds and of U.S. bonds are not identifiably different. Historically, U.S. bonds and foreign bonds have returned about the same, and I expect them to return 1 See
Mr. Rosenberg’s presentation in this proceedings.
Editor’s note: The joint Question and Answer Session of Michael Rosenberg and Lee Thomas follows this presentation.
the same in the future. Academic models do exist that attempt to explain why foreign bonds should carry a risk premium and what some of the determinants of that risk premium might be. For example, as a country increases the number of bonds it is issuing, as Japan is doing, one might expect a risk premium to appear in the pricing of its bonds. Such academic models are generally not useful, however, to practicing portfolio managers. The models are not sufficiently developed to predict in practice where the risk premiums are, how large they are, or even whether a particular risk premium is positive or negative. Experience and the sketchy theory available to predict risk premiums argue that it is best to assume that any developed country’s bond held over a long period of time has about the same expected return as a U.S. bond. This conclusion does not depend on whether the foreign bond is hedged or not. In addition, Rosenberg and I agree that the future volatility of currency-hedged developed market foreign bonds is likely to be similar to the volatility of U.S. bonds. Such similarity has not always been the case. In the past, U.S. bonds have been more volatile than most foreign bonds. Bond volatilities can differ for many reasons, but the most important is the varying monetary policies practiced by different countries. For example, for many years, the Bundesbank held a tighter rein on the German economy than did the Federal Reserve on the U.S. economy. Recently, central bank policies have converged. Everywhere but in Japan, the major central banks formally or informally target inflation and are about equal in skill. This convergence does not mean that foreign bonds are uninteresting as a strategic asset. Even
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13
Global Bond Management II though two assets have the same volatility and the same expected return, we know from modern portfolio theory that unless the assets are perfectly correlated, a portfolio of the two will have less volatility than holding either one of them alone. This lower volatility is the strategic argument in favor of holding foreign bonds. The argument will fail only if interest rate movements in different countries become perfectly correlated in the future, but that will happen only if countries return to fixed exchange rates. Finally, of course I agree with Rosenberg that the benefits (i.e., the amount of volatility reduction) from diversifying in the foreign markets are limited. But although the benefits may be limited, they are still significant. Where do we disagree? I disagree with Rosenberg and with Burik and Ennis on the notion that holding foreign bonds provides no strategic benefit. 2 Why the disagreement? Probably because I look at currency-hedged foreign bonds. If investors do not hedge foreign bonds’ currency risks, I agree that diversifying into foreign bonds will produce little benefit. The amount of exchange rate risk added to the portfolio cancels out the interest rate risk that is diversified away from the portfolio. Foreign bonds and foreign exchange, however, are two separate asset classes. Investors can use foreign bonds but hedge them, and by doing so, they gain the advantage of interest rate risk diversification without the penalty of exchange rate risk. Why, then, are more investors not diversifying into this asset class? The first reason is called “home country bias.” Investors in all parts of the world seem to strongly prefer their own country’s assets to nondomestic assets. The bias is particularly strong in the United States, which has large financial markets and, in general, a populace that, relatively speaking, rarely travels internationally or reads about foreign companies and does not speak foreign languages. As a result, foreign assets seem exotic, puzzling, and dangerous and U.S. investors tend to shy away from them. I predict that the home country bias among U.S. debt investors will change. In my grandfather’s era, for a pension fund to invest in equities was considered irresponsible. In my grandchildren’s era, the notion that foreign bonds or foreign equities are somehow riskier or less desirable than domestic ones will be considered a quaint anachronism. Investors in the United States are in a transition now from an old, relatively isolated economy to a new, more inte2 Paul
Burik and Richard M. Ennis, “Foreign Bonds in Diversified Portfolios: A Limited Advantage,” Financial Analysts Journal (March/April 1990):31–40.
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grated one. An important feature of the new economy is that the United States is part of a global marketplace where capital, among other commodities, moves freely across borders. Globalization is creating new markets and transforming old ones. The nice thing about living in a transition era is that inefficiencies—opportunities to earn excess returns—are more likely to arise in markets that are new or changing. Moreover, domesticonly investors create opportunities for others. Right now, most investors look only at domestic markets. If the marginal investor is not conducting cross-border comparisons, then pricing between assets in different countries can be incongruous, creating opportunities to earn excess returns for astute investors. It is hard to believe that these opportunities will indefinitely be ignored. Instead, expect investors to go global. The second reason U.S. investors are not diversifying their portfolios with foreign bonds is a widely held misunderstanding about the effect of currency hedging. Currency hedging increases the correlation between domestic bonds and foreign bonds. Some believe this higher correlation makes hedged foreign bonds less useful as a diversifying instrument than unhedged bonds. What matters, however, is not the correlation between domestic and foreign bonds but the covariance. Covariance depends on both the variance and the correlation, and hedged bonds have a smaller variance. The misunderstanding about correlation and currency hedging can be illustrated as follows:3 Suppose an asset—say, the S&P 500 Index—is compared with another asset—say, the augmented S&P 500, which is the S&P 500 plus 10 percent when I flip a coin and heads comes up and is minus 10 percent when I flip a coin and tails comes up. The expected returns of those two assets are the same if the coin toss is fair. The volatility of the augmented asset is higher, but it will be less correlated with other stock market indexes. Whenever a random number, such as the result of a coin toss, is added to an asset’s return, the return’s correlation with any other asset will be driven toward zero. This effect does not make the asset more attractive to hold; if it did, investors would be including coin-tossing bets in their portfolios. Adding random noise with zero expected return leaves expected return unchanged, but it increases volatility. Which would you rather own: the S&P 500 or the “augmented” S&P 500? Adding volatility to a portfolio without increasing expected return directly contradicts the goal of a prudent investor. Portfolio managers should ensure that their clients are paid an expected excess return 3I
am indebted to Ronald Layard-Liesching for this explanation.
©2000, Association for Investment Management and Research
Foreign Bonds: A Strategic Asset for every additional unit of risk accepted. This concept can be applied to the issue at hand: If a foreign bond is the combination of a hedged bond plus foreign exchange exposures and the foreign exchange component of that combination has zero expected return, the combination generally will be more volatile than the hedged bond alone.4 Finally, Rosenberg and I disagree about the benefits of investing in high-yield versus low-yield assets. The historical data can be misleading, as he suggested, and the topic is highly complex. The subtleties of this issue are beyond this presentation, but it is well documented that a strategy of buying highyielding currencies and financing the position by borrowing low-yielding currencies has been persistently profitable during the past 25 years. Moreover, only economies enjoying rapid growth can afford to pay high real interest rates to investors. The most rapidly growing economies are likely to be found in the emerging markets. Globalization and the end of the Cold War have improved the growth prospects of many emerging economies. Having outlined how I agree and disagree with my colleague, let me turn to the two reasons for holding foreign bonds—tactical and strategic. 4 If
the correlation between the exchange rate and the bond return is negative, unhedged foreign bonds can be better diversifiers than hedged foreign bonds.
Tactical Benefits of Foreign Bonds Imagine that some investors held the U.S. bond component of the Salomon Brothers World Government Bond Index (WGBI) from 1986 until 1999. Those investors would have tripled their money. But if in each year those investors had been so prescient that they could pick from the Salomon WGBI the single non-U.S. country that would have the highest total return on a currency-hedged basis, they would have made twice as much money during that period as investors who passively invested in U.S. bonds alone. If investors had been so unlucky as to pick from the Salomon WGBI each year the single non-U.S. country that had the lowest total return on a currency-hedged basis, they would have made only half as much money during the 1986–99 period as investors passively invested in the U.S. component. Thus, country selection is important. This outcome has nothing to do with exchange rates; it has to do with knowing which country is going to have the best bond rally, as shown in Figure 1. A USD100 investment in 1986 would have grown to USD150 if invested in the bonds of the non-U.S. country with the lowest return in each year (1986 through 1998), USD300 if invested in U.S. bonds, and USD600 if invested in the bonds of the non-U.S. country with the highest return in each year. In other words, a substantial opportunity would exist for adding alpha to bond portfolios if investors could
Figure 1. Passive U.S. Bond Strategy versus Country Selection, 1986–98 U.S. Dollars 700
600 Best Country Selection
500
400 U.S. Bond Component of WGBI
300
200 Worst Country Selection 100
0 86
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Global Bond Management II predict which markets were going to be the bestperforming markets in the upcoming period. They could use foreign markets the way they use corporate bonds, mortgage-backed securities, or high-yield bonds—as sectors to rotate into whenever the outlook appears propitious. This argument has a downside: A small amount of foreign bonds can add a lot of risk to the portfolio. For example, based on the Lehman Brothers Aggregate Bond Index, a 5 percent overweight in corporates relative to governments will add 5–8 basis points in tracking error; a 5 percent overweight in mortgages will add about 8 bps of tracking error; and a 5 percent allocation to a well-diversified portfolio of currency-hedged foreign bonds will add 18 bps of tracking error. The higher tracking error associated with the additional allocation to foreign bonds arises because foreign bonds are not as highly correlated with U.S. government bonds as are U.S. corporates or mortgages.
Figure 2. Percentage of Domestic Volatility Explained by Foreign Markets, 1996–98
Strategic Benefits of Foreign Bonds
from entirely explained by the variation of world markets. So, the door is open for investors of all nations to diversify into country bond markets other than their own in order to enhance the risk–return characteristics of their portfolios. One question currently being asked is whether the benefits of diversification are disappearing as a single world business cycle emerges. The 1996–98 data do not support this: If bond yields in all the world’s markets were to become highly correlated, foreign bonds would offer limited diversification benefits. The reason some analysts predict an increasing market correlation, I believe, can be attributed to the world situation that existed in 1994. In that year, the entire world was in a bear market. Investors got the notion that when bear markets happen, they happen everywhere. Starting in 1995, however, business cycles around the world again became unsynchronized. It was a period of robust expansion in the United States, but a “growth recession” threatened Europe. (European countries generally experienced growth but not enough growth to reduce unemployment, which still remains in double digits.) Japan was teetering on the brink of depression. The varying monetary and fiscal responses to these situations shaped the succeeding business cycle of each nation. Floating exchange rates were introduced in the 1970s so central bankers could direct monetary policy appropriately and specifically to each country. Not surprisingly, economic policies as well as economic shocks affect countries in unique ways. As a practical matter, the diversification of a bond portfolio is really an attempt to diversify the economic shocks and monetary policy mistakes of
The strategic benefit of adding foreign bonds to a U.S. domestic portfolio increases when the correlation of foreign bonds with U.S. bonds is low. But as long as two assets are not perfectly correlated, investors generally can combine the two assets to achieve reduced volatility without sacrificing return. This outcome is the well-known principle of diversification described by Markowitz. Figure 2 shows the amount of volatility in the domestic bond markets of three developed countries that can be explained by the volatility of the markets outside the country’s home market. I used the most recent data available, 1996–98 data, because as the world becomes increasingly globalized, historical relationships may not accurately reflect current relationships. As Figure 2 illustrates, the recent data still suggest that diversification benefits are possible from an allocation to foreign bond markets: World markets are not moving in lockstep. In the U.S. market, only slightly more than 50 percent of domestic volatility can be explained by the movements of foreign markets. Thus, about half of the variation is potentially diversifiable. For German investors (investors with all their wealth invested in the German component of the Salomon WGBI), about 50 percent of domestic bond return volatility is explained by foreign (nonGerman) bond markets. A Japanese investor has an even more potent opportunity to enjoy the benefits of diversification because, as Figure 2 shows, the Japanese bond market has been moving in a world of its own. The data for these major bond markets make clear that the volatility of domestic markets is far
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Percent Explained 60
50
40
30
20
10
0 United States
Germany
Japan
©2000, Association for Investment Management and Research
Foreign Bonds: A Strategic Asset central banks. Investors who invest entirely in the U.S. bond market today are betting that U.S. Federal Reserve Chairman Alan Greenspan will keep inflation in check. If Greenspan’s policies fail, those investors could be in trouble. It would be better for investors to allot part of their money to the United States, part to the United Kingdom, part to the 11-country EMU (European Monetary Union), and part to Japan—in the hope that all four central banks do not make mistakes. Spreading investments also helps diversify against real, as distinct from monetary, shocks. Real shocks affect economies differently. A change in the price of oil does not affect Japan in the same way that it affects the United States; it will not affect Japanese bonds the way it does U.S. bonds. Examination of the United States, Germany, and Japan—the world’s largest economies—does not support the argument that the world’s bond markets currently operate on a single business cycle. Figure 3 depicts the correlation between domestic and nondomestic bond returns for the United States, Germany, and Japan from December 1987 through November 1999. During the 1980s and 1990s, U.S. Treasury bonds’ correlation with hedged foreign bonds generally moved between 0.5 and 0.7; recently, it has risen
out of this range but only modestly, to 0.75. The correlation between German and hedged non-German bonds is also about 0.75. This correlation rose sharply during the run up to EMU, but since 1995, it has been stable, between 0.7 and 0.8. Japan’s bond market does not show increasing correlation with hedged foreign bonds at all. In fact, this is the only graph showing a strong trend, and that trend is downward.
Conclusion Hedged foreign bonds should be treated as another sector within the fixed-income securities universe. Diversifying across global markets reduces interest rate risk. But to reduce risk, foreign bonds must be currency hedged. If they are not hedged, foreign bonds introduce another distinct asset class into the portfolio, foreign exchange—one asset class that brings with it additional and uncompensated volatility. Only when there is an expected excess return from the exchange rate bet should foreign exchange be introduced into the asset allocation of the portfolio. Foreign currencies should be used opportunistically if they are used at all.
Figure 3. Correlation between Domestic and Nondomestic Bond Returns: U.S., German, and Japanese Markets, December 1987–November 1999 Correlation 1.00 0.90 0.80
German
0.70 0.60
U.S.
0.50 0.40 0.30 Japanese
0.20 0.10 0 12/87
12/88
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Global Bond Management II Why treat bonds and foreign exchange differently? Bonds have associated with them a persistent risk premium; thus, investors expect to earn a return over the risk-free rate even if they simply buy and hold them. Unfortunately, investors who just hold foreign currency through time are not likely to make money. Accordingly, foreign exchange should be viewed purely in tactical terms and deserves a portfolio allocation only when investors have a strong view that the foreign currency will outperform its forward rate. This does not mean that foreign bonds are a strategic asset class. Rather, the logical asset class is global bonds, incorporating domestic bonds and hedged foreign bonds. To support this conclusion, Figure 4 graphs the volatility of a hedged global portfolio (the Salomon WGBI) and a U.S. bond portfolio (specifically, the U.S. bond component of the WGBI). Rolling three-year portfolio volatilities for both portfolios were constructed beginning in December 1987 and ending in November 1999. There has never been a three-year
period when investors could have held a passive portfolio of only U.S. bonds and enjoyed a lower volatility than if they had held a well-diversified, passive global portfolio consisting of U.S. and currency-hedged foreign bonds. If the world’s financial markets were becoming so highly correlated that global diversification no longer provided a benefit, the spread in volatility between holding a global portfolio and holding a U.S.-only portfolio would be shrinking. In fact, however, Figure 4 shows that this difference was relatively constant from 1987 through 1999. During the last three years of this period, a U.S. bond portfolio had a volatility of 4 percent and a global portfolio had a volatility of 3 percent. As Rosenberg and I agree, both of those portfolios have the same expected return; thus, investors have a choice of investing in the U.S. only, producing an expected return of X and a volatility of 4 percent, or investing globally and enjoying an expected return of X and a volatility of 3 percent. The more attractive choice is clear.
Figure 4. Rolling Portfolio Volatility, December 1987–November 1999 Volatility (%) 7.0
6.5
6.0 U.S. Bond Component of WGBI
5.5
5.0
4.5
4.0
3.5
Salomon WGBI
3.0
2.5
2.0 12/87
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Foreign Bonds
Question and Answer Session Michael R. Rosenberg Lee R. Thomas III Question: Mr. Rosenberg, would following the sample trading rule in your Table 2 have produced excess returns also in the 1973–85 or 1988–99 period? Rosenberg: The sample trading rule was simply an illustration of how a tactical portfolio could be run. I was not trying to recommend those particular moving averages or any type of technical trading rule as the motivation for moving in and out of foreign bonds. Still, following the sample trading rule might have yielded excellent returns for 1973–1987. From 1988 on, it probably would not have been as profitable, largely because exchange rates experienced no big moves comparable to those in the 1970s and 1980s. Levich and Thomas have done some work showing that technical trading rules would have generated significant excess returns through 1990.1 During the 1990s, the returns have not been as strong. Question: Mr. Thomas, what method of estimation did you use to explain the contribution of a foreign market’s volatility to a domestic portfolio? Thomas: The amount of domestic volatility explained by foreign volatility is given by the coefficient of determination (R2). To derive more detail requires more subtle analysis. I like to deconstruct the portfolio to identify the marginal contribution to risk from each of 1 Richard Levich and Lee Thomas, “The Significance of Technical Trading-Rule Profits in the Foreign Exchange Market: A Bootstrap Approach,” NBER Working Paper 3818 (1991).
the components. (The mathematics uses Euler’s equation.) Question: What blend between U.S. and hedged non-U.S. bonds is optimal? Thomas: For a passive U.S. investor who doesn’t believe that foreign bonds have a higher or lower expected return than U.S. bonds, the risk-minimizing mix has historically been close to that of the WGBI, about 30 percent U.S. assets/70 percent foreign assets. Once the United Kingdom, Sweden, and Greece enter the EMU, however, the optimal weights will probably change to something closer to 50/50. Question: After the cost of hedging, are the diversification benefits still significant, and what is the most efficient method for hedging foreign exchange risk? Thomas: Running a hedged portfolio is not always more expensive than running an unhedged portfolio. For example, suppose I am running a globally diversified portfolio and I am implementing the portfolio strategy with futures contracts. That is, I hold U.S. bond futures, German bond futures, and so forth to replicate the global index. That portfolio is already currency hedged, so there are no extra hedging costs. Indeed, in order to unhedge the portfolio, I would have to buy currency, which would add to my transaction costs. The same would be true for a portfolio of swaps. So, whether a cost will be associated with currency hedging depends on how the investor runs the portfolio, including what instruments the investor
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uses and how the investor implements the currency hedges. My company uses a combination of devices—futures and swaps, bond repos, forward foreign exchange contracts—depending on what we’re trying to accomplish and what the prices are in the market at a given time. Question: How does the development of a corporate bond market in Europe and the existence of Yankee bonds affect your conclusions about the attractiveness of foreign bonds as an asset class? Rosenberg: When analysts look at U.S. bonds versus foreign bonds, they are usually looking at U.S. sovereign bonds versus foreign sovereign bonds. The reason U.S. fixed-income managers have only the one international fixed-income mandate (foreign sovereigns) and so many more domestic fixedincome mandates is that if the expected return on foreign sovereigns is the same as on U.S. government bonds, the manager can gain higher returns by diversifying into U.S. corporates, U.S. mortgages, U.S. high-yield bonds, and other domestic assets. U.S. fixed-income managers understand the domestic markets and their risk characteristics. Someone who wants to make a case for foreign bonds must first explain why U.S. investors should be looking at foreign sovereigns rather than U.S. corporates, U.S. mortgages, and so on. U.S. investors do not invest in foreign corporates and foreign high-yield instruments because these markets are not yet fully developed. Today, portfolio managers are limited as to what they can add from those markets. This
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Global Bond Management II situation will obviously change over time. Then, U.S. investors will have to ask themselves how foreign corporate bonds are performing relative to U.S. corporate bonds. Foreign sovereigns provide no excess return relative to U.S. governments, so should we expect any excess return from foreign corporates relative to U.S. corporates? How far down the credit-risk structure will U.S. investors have to move to get higher returns in foreign markets than similar markets in the United States? This issue is going to be the key. Thomas: European markets are changing, and the big story of the next decade will be how U.S. investors can exploit new products, such as corporate bonds, as they develop in Europe. This change may be to the advantage of U.S. investors, who are familiar with using these instruments in the U.S. market. Currently, in Europe, the corporate bond market is substantially an upper-tier market, dominated by issues with ratings of AA or AAA, but recently a junkbond market has developed. And the rest of the credit spectrum will fill in, in part as a result of competition among European bankers.
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Europe has far too many banks. With the EMU in place, competition among European banks is already leading to mergers and acquisitions. Only a handful of banks will emerge as the victors, which is why Deutsche Bank and others are trying to grow so quickly. They want to make sure they are the acquirers. To do so, they must raise their return on equity (ROE). In the past, the European corporate bond market was small because banks made sweetheart loans to their corporate clients to cement their relationships and then made their revenue on other banking fees. As European banks become more ROE focused, they are likely to turn away some corporate clients, and those clients will go to the bond markets to raise funds. Fortunately, European corporate borrowers will hit the bond markets at just the right time. European governments are trying to salvage their bankrupt pension systems by encouraging private pension plans. With little opportunity existing to add alpha from active, top-down, macroeconomic management—a consequence of EMU—investors will be looking for spread products offering higher yields than government bonds. In its early stages, the new European bond market is likely to
have many inefficiencies This will provide an excellent opportunity for U.S. portfolio managers. U.S. expertise in corporate bond management, corporate credit analysis, mortgage-backed securities, assetbacked securities, and so forth, will be needed. U.S. managers are already familiar with these sectors. It promises to be an exciting market. Question: What about the option of using tactical foreign exchange management instead of limiting choices to hedged and unhedged foreign bonds? Rosenberg: I am in favor of tactical foreign exchange management as one more tool in the management process. Currency decisions are critical in the global fixed-income decision process. Many international fixed-income managers would probably say that currency management is a major part of what they do. Some in the industry argue that foreign bonds are simply a vehicle for speculating in the currency markets. Because pension managers are not allowed to allocate money for pure currency speculation, they hire global fixedincome managers who are actually closet currency speculators.
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Currency Management: Protection or Return? Ronald Layard-Liesching Managing Director and Chief Research Officer Pareto Partners
Currency exposure in a global bond portfolio introduces risk without producing a commensurate expected return. To understand currency risk in a global bond portfolio, investors need to know the sources of risk and return in global bonds. Specifically, they must understand the distinction between investments and exposures and the very high time concentration of currency moves. Currency market timing based on economic fundamentals has not proved to be dependable. The structural change in the currency markets and the recent shift in portfolio investment flows make forecasting currency movements difficult. Measuring currency risk, however, is possible, and by measuring currency risk, value can be added. Currency risk management is vital and provides a reliable method for improving the efficiency of global bond portfolios.
hether currency in a global bond portfolio provides greater diversification and higher riskadjusted returns is a matter of dispute. To answer the question, the investor must first consider the role currency plays in terms of the risk and return of global bonds, the structure of modern currency markets, the reliability of fundamental forecasting models, and the reported results of currency managers in actually adding value through currency management. Currency management as a separate portfolio management technique has emerged only in the past decade. Academic research has not yet generated dependable currency-forecasting models, and this lack of success strengthens the argument that currency returns are random. Research continues, but in the meantime, currency poses a quantifiable risk to the global investor that must be actively managed.
W
Currency in a Global Bond Portfolio To appreciate the role currency plays in a global fixedincome portfolio, the investor must understand the four sources of risk and return associated with global bonds: country selection, duration, credit exposure, and currency exposure. Does currency add to or detract from these sources of return? Of particular concern is the risk unique to currency of a very highly time-concentrated pattern of return. Furthermore, is currency—and this question can also apply to other
investment activities—an investment or an exposure? I argue that currency is an exposure and that there is an important distinction between the two classifications in terms of risk and return. Sources of Risk and Return in Global Bonds. Consider the risks of an unhedged global bond portfolio. Suppose a U.S.-dollar-based investor buys a Japanese-yen-denominated bond with a 0.9 percent coupon and a five-year maturity. Assume that this investor does not hedge the JPY/USD currency risk. This investor has invested in a bond with multiple risks: country selection, duration, credit, and currency. The investor may feel confident about making bets on country bond market movements, the bond’s duration, and the credit of the issuer. The investor may not feel comfortable with the currency component of the investment. This last risk may be one risk too many for a prudent investor, particularly in light of the apparently random nature of currency returns. “Going naked” (unhedged) on the currency is a difficult choice for most investors. Instead of being vulnerable to JPY/USD movements by holding the Japanese bond, the U.S. investor could create a synthetic U.S. bond from the Japanese bond by entering a JPY/USD currency swap. This swap would convert the yen interest and principal payments due over the life of the bond into U.S. dollar payments. If the investor is lucky, the
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Global Bond Management II swap market may allow a small positive spread on the currency swap. Other than this small spread, the strategy provides minimal opportunity to earn an excess return over any U.S. bond with similar characteristics. From an investor’s perspective, the return opportunities associated with a completely hedged foreign bond are usually too small to make this activity interesting. The process merely converts the Japanese bond into a U.S. bond but with a foreign credit risk. In the real world of global bond investing, however, global bond managers would normally choose to do a short-date—maybe one to six months—rolling foreign currency hedge, instead of a complete currency hedge. With a short-date hedge, currency protection can be easily extended or removed depending on the manager’s view of future cross-rates. The net result will be a currency hedge, but there will also be an interest rate mismatch because the manager is forced to ride the interest differential versus the foreign yield curve. Thus, the multiple risks of country selection, duration, foreign credit, and currency remain in the picture to some degree. But by using a partial, short-date currency hedge, global bond managers can select the parts of risk with which they are comfortable. For example, a manager may use a longer-date foreign exchange (FX) hedge if the shortterm direction of cross-rates is unclear. The primary sources of return from a global bond portfolio mirror the sources of risk: country selection, duration, credit—and possibly currency, depending on its role. Although a global bond manager can certainly add value by using sophisticated techniques that extend beyond the basics, such as derivatives, for large portfolios in which liquidity concerns are foremost, these four sources of risk and return are the most important. Global bond managers can provide clients with an attribution of their value added for each of these four components. ■ Country selection. Country selection appears to dominate the asset allocation decisions of most global bond managers, which may very well be an appropriate use of their clients’ risk budget. The U.S. bond market is one of the most efficient markets in the world. So, why should a manager stay in the U.S. bond market, where the sophisticated market makers have “arbitrage free” stochastic bond models wired into the Bloomberg terminal with real-time execution? Faced with a dearth of exploitable inefficiencies within the U.S. bond market, and with half of the world’s fixed-income markets outside the United States, bond managers understandably focus a great deal of attention on country selection. In theory, country selection works because of “macroeconomic desynchronization” among the
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bond markets—that is, timing differences in national economic cycles that provide opportunities to add substantial value to portfolios. For example, by exploiting the fact that Japan is in economic turmoil or that European countries are coming out of a recession, the global manager is engaging in macroeconomic arbitrage as a strategy to earn an excess return. ■ Duration. The manager’s decision of which bond maturity to select within a market is the duration decision. Ultimately, duration is a timing decision. Timing decisions are often dangerous to an investor’s financial health. Consider the impact of market timing within the U.S. bond market. Figure 1, based on monthly data, shows the number of months that U.S. T-bonds outperformed U.S. T-bills and that U.S. equities outperformed U.S. T-bonds in the 1984–99 period. These graphs illustrate that in only a small percentage of months did either T-bonds outperform bills or equities outperform bonds. The graph of bond–bill relative returns indicates that if only the top 9.0 percent of outperforming months in the 15-year period were eliminated, then T-bond returns would equal bill returns. Because of the 9.0 percent of outperforming months, T-bonds earned 3.13 percent more than bills over the period. But if the top 20.0 percent of outperforming months were eliminated, T-bond returns actually would be lower than T-bill returns by 2–3 percent. In other words, if in attempting to time the market an investor in U.S. T-bonds missed the top returning 9.0 percent of months, that investor would have earned only a cash-equivalent yield on the investment. Figure 1 shows that the dubious benefits of timing also apply to the equity markets. The outperformance of equities over bonds—8.18 percent—is concentrated in only 10.1 percent of the months during the 15-year period. The conclusion suggested by these data is that being permanently invested is crucial to capturing the high returns, because positive relative performance occurs in only a small percentage of months. These statistics explain the poor performance of market timing in the bond and equity markets. Actual experience of U.S. funds confirms that timing markets is a poor use of the aggregate risk budget. ■ Credit. Often a manager’s strategy to add value includes investing in corporate securities to earn a positive yield spread, or premium, over sovereign debt. Managers are confident in their analytical skills and thus in their abilities to identify credit yieldspread inefficiencies, but disclosure from many companies in the international market is often poor. Although the return to normal yield spreads from abnormal levels can provide return, this return is highly correlated with the direction of rate movements and comes at the cost of significant liquidity risk.
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Currency Management Figure 1. Timing Risks: T-Bonds versus T-Bills and U.S. Equities versus T-Bonds, January 1984–September 1999 Relative Outperformance (%) 10
5
0 U.S. T-Bonds versus U.S. T-Bills –5
–10
–15
U.S. Equities versus U.S. T-Bonds
–20 0
10
20
30
40
50
60
70
80
90
100
Monthly Observations (%) Sources: Data are from Salomon Brothers and the S&P 500 Index.
In most global bond portfolios, the return from the interest rate bet is a much greater contributor to total return than is the marginal return generated by the credit-spread bet. Because of the small size of global private credits and their illiquidity, most managers still look for the majority of return in country selection, duration, and currency bets. ■ Currency. In a fully invested global portfolio, capital is not actually invested in currency per se but in the foreign securities denominated in various currencies. In a global bond fund, the net capital is invested in bonds. Zero additional capital is involved in the creation of the currency exposure. This distinctive characteristic of currency being an exposure adds a layer of complexity to the role currency plays in investing. Because no net capital is invested to create the currency exposure, the investor cannot expect a currency-related return over the long run. Indeed, if a return were expected for merely passively holding foreign currency positions, then arbitrageurs would quickly eliminate this market inefficiency. Yet, despite the lack of expected return, major risk is certainly associated with the presence of currency in a portfolio. The primary risk associated with currency arises from the episodic nature of currency movements, their lack of predictability, and the associated impact on the timing decisions of managers.
Figure 1 provided information about the questionable benefits of timing in the bond and equity markets. Figure 2 looks at currency in the same way. Again, the data were sorted into high-returning and low-returning months for value added by foreign currency to a U.S. dollar portfolio for 1984–1999. The result is that the substantial value added by currency over this period, 3.2 percent a year, was concentrated in just 4.5 percent of the months. Keep in mind that this analysis used monthly data; with daily data, there is an even greater time concentration in currency returns. For instance, in 1998, the yen started the year at 130 to the U.S. dollar and ended the year at 109, which is a 19 percent upward movement in a year. The trouble is that the move was not gradual; it was concentrated in less than four nonconsecutive days. So, currency market movements have been extremely time concentrated. If currency exposure is expected to add value, the manager must actively manage that exposure to benefit from the rapid and often unforeseeable realignments in currency cross-rates. Time Concentration of Currency Returns. To emphasize the importance of timing in the currency markets as a contributor to the total return of a global bond portfolio, Figure 3 illustrates a U.S. dollar overlay in a pound-sterling-based portfolio from March 1993 to March 1999. This graph shows that value added by currency exposure is highly episodic.
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Global Bond Management II Figure 2. Timing Risk: Foreign Currency versus the U.S. Dollar, January 1984–September 1999 Relative Outperformance (%) 10
5
0
–5
–10 Foreign Currency versus U.S. Dollar –15
–20 0
10
20
30
40
50
60
70
80
90
100
Monthly Observations (%) Sources: Data are from Salomon Brothers and Pareto Partners.
Figure 3. Currency Overlay: USD/GBP, 1993–99 USD/GBP 110
105 Overlay Result 100
95
90
85 Unhedged Currency Translation Return 80 1993
94
95
96
97
98
99
2000
Note: Years as of March.
For three years, the currency overlay added no value. This result is not surprising, because the British pound had shown no net move against the U.S. dollar. Then in 1996, over a three-week period, the overlay added a 10.2 percentage point return. Thereafter, the currency component of the portfolio resumed a random
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pattern of returns. So, to benefit from the currency move, active management had to be continuously in place so that the time concentration of returns would not be missed. One downside of an active currency overlay is that significant periods of time may pass without any opportunity to add value.
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Currency Management times called “manager alpha”). Mean–variance techniques are inappropriate in analyzing exposures. Because no net capital is employed, risk cannot be measured as volatility. (Put simply, there is no denominator of capital invested against which to calculate the variability of return.) For exposures, risk of loss is the more pertinent measure of portfolio risk, which is why, for example, all hedge fund managers report maximum drawdown statistics. To demonstrate the potential risk of loss associated with the currency exposure of an international bond portfolio, Figure 4 shows two histograms—one of bond returns and one of currency returns. The heavy vertical line in each graph represents the mean of the return distribution. Panel A illustrates the
Investment versus Exposure. When discussing currency effects in a global bond portfolio (or, in fact, the effects of any asset class on a portfolio), a distinction should be made between an investment and an exposure. This difference is intrinsic to the question of how a manager should use currency management techniques. In any active management of actual capital, the return can be divided into two components: a passive market, or index, portfolio (the actual investment) and an actively managed long–short position versus the index (the exposure). The investment gains a passive return from the risk premium of the capital invested in the asset. Ideally, the exposure gains from the manager actively altering the exposures (this source of return is thus some-
Figure 4. Risk of Loss Associated with Currency Exposure: One-Month Annualized Returns, January 1984–September 1999 A. Hedged Bond Returns Frequency (%) 80
60 Loss
Gain
40
20
0 –0.4
–0.3
–0.2
–0.1
0
0.1
0.2
0.3
0.4
Return
B. Currency Returns Frequency (%) 50 40 Loss
30
Gain
20 10 0 –0.4
–0.3
–0.2
–0.1
0
0.1
0.2
0.3
0.4
Return Note: Returns are U.S. dollar based. Source: Data are from Salomon Brothers.
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Global Bond Management II These graphs indicate that net capital investment in bonds is rewarded with a positive return over time. The currency component, which is an exposure with zero net capital investment, provides no expected return. The same results occur when a 24-month period of bond and currency returns is plotted. So, to merely add currency exposure to a global bond portfolio does not enhance the expected return of the portfolio. The currency exposure does, however, substantially increase the risk of loss. Two basic currency management styles attempt to address this risk: currency forecasting and risk management. They both seek to add value but approach the task in different ways.
bond-return component of a hedged U.S.-dollarbased global bond portfolio (based on one-month annualized data). Panel B shows the associated currency returns. The range of returns for both currency and bond components is narrow. The risk of loss for the currency component, however, is nearly identical to the potential for gain, which is not true for the bond component. Figure 5 shows bond and currency returns for the same portfolio for a 12-month period. The mean return for the bond component (Panel A) during the period is positive (reflecting the return premium arising from investment of capital in bonds). In contrast, the mean return for the currency exposure (Panel B) is close to zero.
Figure 5. Risk of Loss Associated with Currency Exposure: 12-Month Annualized Returns, January 1984–September 1999 A. Hedged Bond Returns Frequency (%) 40 30 Loss
Gain
20 10 0 –0.4
–0.3
–0.2
–0.1
0
0.1
0.2
0.3
0.4
Return
B. Currency Returns Frequency (%) 20
15 Loss
Gain
10
5
0 –0.4
–0.3
–0.2
–0.1
0
0.1
0.2
0.3
0.4
Return Note: Returns are U.S. dollar based. Source: Data are from Salomon Brothers.
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©2000, Association for Investment Management and Research
Currency Management
Currency Market Structure and Forecasting The ability to forecast currency movements is influenced by the structure of the global currency markets. Major changes have occurred in currency markets over the past two decades. Turnover in the currency markets is surveyed every three years by the Bank for International Settlements (BIS). About 200 currencies can be priced, and 150 of them can actually be bought or sold—that is, they are free of FX restrictions. Only about 20 currencies, however, have sufficient liquidity to be traded in size. Actual currency management focuses on the six major currencies, which trade around the clock (U.S. dollar, Japanese yen, euro, Swiss franc, Australian dollar, Canadian dollar). These six account for 80 percent of all trading in the FX markets. The daily turnover in these six currencies is USD1 trillion according to the triannual 1998 BIS report. That amount is approximately equal to 30 times the daily turnover in all the global equity markets combined, including the emerging markets. In other words, the turnover in the 35,000 equity securities traded around the world is equal to only 3 percent of the turnover in six currencies. So, currency is the most liquid market in the world. Bid–offer spreads can be as tight as 0.01 percent—to which no other market comes close. In addition to liquidity, the currency markets are characterized by a lack of any significant barriers to entry. Macro information is universally available to all participants. In the past, central banks intervened regularly to support their currencies. Now, the influence of central banks is marginal. For example, the entire foreign exchange reserves of the European Central Bank amount to half an hour’s trading in the London time zone. What has happened is a privatization of the world’s foreign exchange reserves. There are no longer any dominant participants in this market. Thus, currency markets fulfill every condition for market efficiency—liquidity, few barriers to entry, universal information, and lack of domination by a few participants. Therefore, currency returns should be random and not forecastable. So, the market structure presents a challenge to the many economists and investment managers who believe that consistent currency return forecasting is possible. Most economists believe that currency movements are linked to economic fundamentals and technical factors. The major fundamental factors economists consider in making currency forecasts are the different price levels, trade positions, payment flows, interest rates, yields, money growth, real growth of countries, exchange rate trends, and price
reversion (error correction). Academic research does not support fundamental currency forecasting. In their landmark research, Meese and Rogoff analyzed the flexible exchange rate models of the 1970s.1 These forecasting models incorporated future fundamentals, such as the next year’s inflation rates and trade. Yet, even knowing the next five years’ fundamentals, the models did not beat tossing a coin. Goodhart found similar results.2 Analyzing purchasing power parity, he found that large currency deviations from PPP levels actually change the fundamentals, thus justifying the new exchange rate. He called this currency behavior “a random walk with a dragging anchor.” These conclusions were disappointing for those trying to forecast currency moves. Another basic issue in currency forecasting is volatility. Recent FX volatility cannot be explained by fundamentals. For example, Table 1 shows that the volatility in the USD/JPY exchange rate increased in the 1994–99 period as compared with the 1980–85 period. In marked contrast, the differential inflation rate and differential interest rate volatilities decreased. It is not possible to explain increased currency volatility with fundamental variables that are experiencing markedly reduced volatility.
Table 1. USD/JPY Exchange Rate Volatility versus Differential Interest Rate and Inflation Rate Volatility Volatility
1980–85
1994–99
Exchange rate
11.76%
14.21%
Differential interest rate
11.25
1.58
Differential inflation rate
7.96
4.18
Analysis of the economic fundamentals in forecasting currency movements presents another problem. Figure 6 shows the JPY/USD exchange rate and the differential external deficit between the two countries from 1980 through 1999. Conventional theory states that countries that have large deficits have weak currencies. The graphs indicate that the U.S. bilateral trade deficit rose by 35 percent from January 1995 to March 1999; in the same period, the yen fell against the U.S. dollar by 23 percent. The fundamentals do not offer an obvious or intuitive explanation for this large short-run move. Was the currency realignment driven by trade flows, or was the growing deficit driven by 1
Richard A. Meese and Kenneth Rogoff, “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics (February 1983):3–24.
2
Charles Goodhart, “The Foreign Exchange Market: A Random Walk with a Dragging Anchor,” Economica (November 1988):437– 460.
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Global Bond Management II Figure 6. JPY/USD Exchange Rate and Trade Deficit, 1980–99 A. Falling JPY/USD Rate JPY/USD 300 250 200 150 100 50 1980
82
84
86
88
90
92
94
96
98
2000
96
98
2000
B. Rising Differential U.S.–Japan Deficit Differential External Deficit (USD billions) 0 –100 –200 –300 –400 –500 1980
82
84
86
88
90
92
94
Note: 1999 data ending in September.
currency movements, which were, in turn, driven by other factors? The answer lies in a massive structural change that has altered the whole dynamic of the world’s currency market. This dynamic is the switch in dominance from trade (exports and imports of goods and services) to financial investment flows in the currency market. In 1976, 25 percent of all FX trading was trade driven; in 1998, only 1.1 percent of all currency transactions were related to trade. This shift represents the globalization of international investment. For example, in 1991, a large U.S. institutional investor (assets more than USD10 billion) had, on average, some 3 percent of assets invested internationally. Today, if emerging markets are included, a similar investor has, on average, 25 percent invested internationally. The same internationalization of institutional asset holdings occurred rapidly in Europe after the adoption of the
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euro. European funds were forced to invest into noneuro markets in a search for adequate diversification. This caused the euro to fall. Japanese institutions are now also increasing nondomestic investment. Thus, investment-driven cross-border flows are driving the growth in the currency markets. Trade-related flows are a marginal component of total flows. Despite these structural changes, currency forecasting based on global monetary and fiscal fundamentals is still widespread. For managers implementing a fundamental approach, their forecasts relate to a longer-term horizon. Fundamentals change slowly, so heavily fundamental approaches are less active and tend to keep relatively fixed positions. If the currency is below the purported “equilibrium,” then the fundamentalist will stay overweight the foreign currency. If the currency is
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Currency Management above the estimated “equilibrium,” then the manager will stay underweight. With fixed (and often extreme) positions, fundamental approaches tend to produce both the best and the worst short-run returns: After a sudden large move, one group will be “right” and the other “wrong.” You are unlikely to hear from the poorly performing group.3
The Performance of Currency Managers Whether currency managers pursue forecasting or risk management, the determination of how successful currency managers actually are is affected by several biases. ■ Survivor bias. Perhaps the most important bias is survivor bias: Only the fit survive to remain in business and, as a result, in the universe of managers. This effect is clearly shown in the decline in reported added value in the major surveys. The latest survey substantially corrects for the survival bias that was present in earlier surveys: The reported average value added of 1 percent a year can be compared with the 1.9 percent reported in early survey results.4 ■ Reporting bias. Managers who are successful report their results widely. Managers who do not add value do not report their results (and several have left this activity). Articles very rarely report disappointing results of currency management. A variation on reporting bias is a common reporting behavior called the “conjunctive fallacy,” expounded by prospect theorists Kahneman and Tversky.5 As analysts gain more independent pieces of information supporting a view, their subjective probability rises as a result of adding the probabilities of the individual pieces of information. In probability theory, the independent probabilities should be multiplied together, which gives a much reduced combined probability. This phenomenon was shown prior to the creation of the euro; the multiple, separate fundamental indicators led to enormous and misplaced overconfidence that the euro would rise against the U.S. dollar. 3
There is no academic evidence that slowly changing fundamentals can forecast fast-changing, short-run currency moves. But recent research by Nelson Mark (Ohio State University) and Ronald MacDonald (Strathclyde University), Sushil Wadhwani (U.K. Monetary Policy Committee), and Dick Levich (New York University) suggests that some weak evidence of fundamental forecasting value exists.
4 J. Baldridge, B. Meath, and H. Myers, “Capturing Alpha through
Active Currency Overlay,” White Paper, Frank Russell Company (May 2000). 5 Daniel
Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision Making under Risk,” Econometrica (1979):263–91.
■ Emergence bias. Because most global bond managers did not have long track records in separate currency management, they used performance attribution based on historical numbers to isolate the currency return in their bond portfolios. Some no doubt found they had subtracted value by their currency management, and some found they had added value. Those managers who had found themselves to be successful then held themselves out to be (or emerged as) currency managers. They had long-run track records of positive currency returns. Because these managers have not generally had a specific approach to achieving consistent currency returns, subsequent results have in some cases been disappointing. ■ Short-run bias. Short-run track records are worrisome in any market study, but given the instability of currency returns, conclusions from shortperiod data on currency management are not statistically meaningful. Currency overlay—management of currency risk that someone else has created—is a relatively new activity. Although some managers have a 10-year history in currency management, the average manager has a performance history shorter than 5 years. Most of the track records are U.S. dollar based. Figure 7 demonstrates the strong value added by currency hedging in a U.S.-dollar-based portfolio. In the period from January 1996 to late 1999, foreign currencies fell by 19 percent. If managers had fully hedged, they would have been 19 percent better off. In fact, any currency hedging at all during this period would have added value, particularly when the benchmark was unhedged or, at most, 50 percent hedged. How skillful is it to add value when any hedging would add return? The results of broad currency management strategies and specific currency managers should always be weighed in light of these four biases. Alone, or in tandem, these biases could meaningfully influence investor decision making and mandate selection.
Conclusion The global currency markets have undergone huge structural changes in the past two decades—massive payment imbalances, globalization of financial flows, the increasing popularity of derivatives and options, and the unprecedented arrival of the euro. As a result, currency models that worked 10 years ago are severely challenged to operate satisfactorily today. Nevertheless, research indicates that currency risk goes unrewarded over time, and this risk of loss is high and largely unpredictable. Fundamental forecasting strategies are often unreliable, and reported performance of currency managers is not straightforward. How, then, should investors approach the issue of currency risk?
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Global Bond Management II Figure 7. Currency Return on the EAFE Index, 1996–1999 January 1996 = 100 110
105
Fully Currency-Hedged Return
100
95
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The literature on generalized autoregressive conditional heteroscedasticity modeling, stochastic volatility, value-at-risk analysis, and extreme value theory all confirm that currency risk can be measured. Measuring the risk is the only way to begin to manage it successfully. Aggressive market timing in the pursuit of currency return, however, is a risky management strategy; the risk of big currency movements over very short time periods is high. A continuous, active currency overlay is a practical strategy that can reliably capture this potential source of return. Plan sponsors have used both risk-oriented techniques and forecast-based approaches to add value. Despite all the difficulties in managing currency positions, active currency management can dramati-
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cally improve efficiency in global bond portfolios. It enables a manager to allocate assets to the largest number of available markets. For example, if the portfolio manager likes the Australian bond market but is concerned about downside risk in the Australian dollar, currency risk management can protect the investor and also open the door to greater diversification and return opportunities. The bottom line is that managing currency risk is an inescapable component of global bond investing. Actively managing this risk can significantly enhance the return to the client’s risk budget. For this reason, attribution to determine currency management skill is important for evaluating global bond managers’ credentials.
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Currency Management
Question and Answer Session Ronald Layard-Liesching Question: Would currency management make sense for a manager with a mandate of less than USD1 billion? Layard-Liesching: Currency management tends to be an activity for the big funds, particularly when a separate currency management mandate exists. Three rules of thumb for currency managers are (1) more than 10 percent of managed assets should be outside the base currency, (2) the amount of this non-base-currency exposure should be greater than USD200 million (if it is less than USD200 million, the currency exposure is simply too small to worry about), and (3) a currency investor should have adequate resources to devote to the currency issue. Currency management is complicated and should not be undertaken without what is an often time-consuming study. Question: Which currencies do you use most frequently?
Layard-Liesching: First, emerging market currencies cannot be actively managed. Managers can certainly examine the risks in those currencies and use that information beneficially, but they cannot actively manage those currencies; they are too illiquid, and the markets cease to trade when they are really needed for hedging. That said, different currency management styles use different currencies. Typically, a global equity portfolio will be exposed to as many as 20 currencies; for a bond portfolio, the number might be a little less. But not all of those 20 currencies trade 24 hours a day. So, the first step is to use a smaller basket of currencies to proxy the true exposure. The size of that basket will vary depending on the exact currency exposures in the portfolio. The proxy basket might hold three to six currencies, and those currencies would be the usual candidates. That is, from a U.S. dollar base, the basket currencies would probably be the euro,
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the Japanese yen, and the British pound. Beyond these three, the choice might be the Australian dollar, the Canadian dollar, or the Swiss franc. Question: Can you comment on the success of using currency manager polling for forecasting? Layard-Liesching: One of the big problems with behavioral finance models in currency management is reporting bias. The interaction of reporting bias and the time-frequency sensitivity that is characteristic of the currency markets is the main reason polling is not an effective forecasting tool in the currency markets. In polling, successful managers report positive performance; unsuccessful managers do not report. Therefore, poll results are not representative of the vagaries of the currency markets and the realities of currency management.
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Can Sovereign Defaults Be Forecasted? David Anthony Manager, Country Risk Service Economist Intelligence Unit
Globalization, liberalization, and privatization, particularly in the developing countries, are changing the nature of sovereigns and sovereign debt finance. These dynamics will inevitably require new processes for assessing sovereign debt risk and the likelihood of sovereign debt default. Sovereign debt defaults can rarely be accurately forecasted, but risk analysis can be improved by taking into consideration the principal forces shaping the new world economy: globalization, regionalism, financial market innovations, the changing nature of emerging market sovereigns and their debt financing methods, and the changing role of multilateral agencies.
s global investors have stretched the boundaries of investing beyond domestic and developed country markets and into emerging markets, their ability to correctly assess the likelihood of sovereign default has acquired increasing importance in risk management. Accurately assessing the likelihood of sovereign debt defaults requires judgment about two broad, key elements: when the default is likely to occur (timing) and the potential impact of default (magnitude). Sovereign debt risk analysis must reflect the constant shifts in economic and political situations as well as changing relationships in the global economy, which have been occurring regularly in recent years. Although the lessons of one crisis may have useful applications for risk analysis, no two countries are exactly alike in their political processes, monetary and fiscal policies, or basic economic fundamentals. Countries threatened with default can often pull back from the brink of disaster with international assistance, such as that provided by the International Monetary Fund (IMF). Governments can change their policies or negotiate with creditors preemptively to avoid a technical default. Consequently, the conditions that might constitute a sovereign debt default in one country may be entirely different in another country. Because of these difficulties, correctly forecasting sovereign defaults is almost impossible. Rather, the analyst’s role is to highlight the risk elements that might indicate the likelihood of sovereign default. The standard methodology used to assess sovereign debt risk can be improved in several ways. This pre-
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sentation begins with discussion of a few basic concepts about sovereign debt risk analysis and some generally accepted criteria for rating sovereign debt risk. It then turns to the challenges posed to analysts by the changing nature of sovereigns and sovereign debt finance and offers recommendations for improving country risk reports to address these issues.
Basic Concepts Three basic concepts are fundamental for forecasting sovereign debt defaults: default, default determinants, and the sovereign. The emphasis of sovereign debt risk analysis needs to be refocused on these concepts unique to the sector. ■ Default. Default means noncompliance with the terms of a contract. The terms refer to timing, completeness, and maturity of both principal and interest payments and to any special clauses. Default can be partial or complete, depending on whether the sovereign pays its obligations in full or selectively. ■ Default determinants. Two broad themes determine a sovereign’s likelihood to default: its willingness to pay and its ability to pay. Willingness to pay broadly reflects political risk; ability to pay is mostly influenced by economic risks. ■ Sovereign. A sovereign is a unique type of entity in economics. It is elected or imposed and does not operate with a profit motive. A sovereign is not a unified organization; it may be separated into federal, state, and corporate sectors—each with its varying goals and motivations. The sovereign creates and wields legal power and often contributes a sizable share of GDP. Its main tool of operation is policy
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Can Sovereign Defaults Be Forecasted? management. It has extensive control over a country’s exchange rates and tax system, and its policy framework influences domestic financial markets. The legal power of sovereign governments limits the redress creditors can obtain in the event of sovereign default. The sovereign has reciprocal links with households and businesses, so the financial health of the sovereign depends on the financial health of these sectors. And the sovereign is sometimes the lender of last resort to corporations and banks in the country.
meet foreign currency debt-servicing requirements, however, the sovereign must acquire the foreign currency in which the debt is denominated. The currency can be obtained through either trade flows or investment flows, but both sources are subject to global political and financial market conditions over which the sovereign has, at best, limited control.
Criteria for Default Assessment
The current process of assessing sovereign risk and the likelihood of sovereign default must be improved to reflect the changing nature of governments and government debt finance, particularly among the emerging market countries.
The sovereign’s ability and willingness to pay debt service in a timely manner to avoid default primarily depend on four elements: political climate (political risk), economic policies and structure (economic risk), liquidity (liquidity risk), and relative currency valuation (currency risk). ■ Political risk. The political risk factor has two core elements: the stability and the effectiveness of the political system. The stability element encompasses the presence or likelihood of serious internal conflict or international disputes, social unrest, and the orderliness of political transfers. The effectiveness element concerns the government’s pro- or antibusiness orientation, institutional effectiveness and transparency, and the amount of bureaucratic corruption. ■ Economic risk. The economic risk factor also has two elements: policy and structure. The quality and consistency of economic policy are influenced by the sovereign’s fiscal, monetary, trade, regulatory, and exchange rate regimes. Structure is central to the sovereign’s solvency and includes the growth–savings–investment triangle; the magnitude, trend, and cumulative position of the current account; the sovereign’s default history and annual debt service; and the sovereign’s financial health as measured by debt ratings, balance sheet analysis, and the extent of financial system regulation. ■ Liquidity risk. The liquidity risk factor is concerned with potential imbalances that could disrupt the stability of the financing instruments at the sovereign’s disposal. Foreign exchange reserves, shortterm debt burden, debt maturity structure, access to international capital markets, and the means– spending ratio are all used to assess liquidity risk. ■ Currency risk. Currency risk is a function of the sovereign’s political, economic, and liquidity characteristics. Currency risk is critical to external debt servicing. A clear difference in default risk exists between local currency and foreign currency debt. The sovereign has control over domestic fiscal and monetary policy, which provides substantial flexibility in meeting local currency debt-servicing needs. To
Changes in Sovereigns and Sovereign Debt Finance
Sovereigns. The changes governments are undergoing are both internal and external. Internal changes are primarily attributable to the reform programs enacted and enhanced during the 1990s. Of the 100 countries that the Economist Intelligence Unit (EIU) Country Risk Service (CRS) covers, only two—Iraq and Yugoslavia—are not formally following some type of reform program. Reform has taken place primarily on the fiscal side and has emphasized spending restraint and the streamlining of the state, mainly through privatization. The liberalization/deregulation paradigm has opened up trade and capital markets. Furthermore, the state’s role has gradually shifted from provider of goods and services and lender of last resort to regulator of the country’s corporate and financial sectors. Externally, an equally significant change has occurred in recent years. Financial market globalization has increasingly integrated emerging markets into the international economy. The deregulation of financial markets has created a boom in foreign currency bonds in general, and combined with recent low international interest rates, deregulation has spurred developed country investors to reach for yield, generating a boom in emerging market debt. Deficit financing has also undergone change. Governments that have chosen to institute reform programs are more prudent than they used to be in how they finance deficits. Inflationary monetization of fiscal deficits is now frowned upon as a financing solution. With reform, many governments have been able to tap deeper into local capital markets and to move into the global financial markets. Sovereigns have more options than in the past in the sources, instruments, and terms of their financing arrangements. These broader financing choices have given developing country governments greater sophistication and flexibility in deficit financing.
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Global Bond Management II From Loans to Bonds. Commercial bank borrowing was the accepted means of sovereign financing in the 1970s and early 1980s, but with Mexico’s default threat in 1982 and the resultant Brady bond restructuring of much of Latin America’s commercial bank debt, the borrowing form of choice began to change. Stung by the Latin American debt crisis of the 1980s, commercial banks reduced their exposure to emerging markets in the syndicated loan market. This change, together with liberalization of financial markets in developed economies and growing confidence in the policies pursued in emerging markets, encouraged bond issuance, which began to replace loans as the primary financing vehicle for sovereigns. Figure 1 illustrates this shift in the 1990s. After the recent financial crises in Russia and Asia, international capital markets were closed to many developing country borrowers, which has necessitated a return to commercial lenders, albeit with stiffer credit terms than previously required. Even the type of bonds being issued has changed. The stock of Brady bonds, which expanded
Figure 1. The Shift from Loans to Bonds, 1980–98 Percent of Total 60
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rapidly in the first half of the 1990s as debt restructuring agreements were reached, is now declining as a result of amortizations and buybacks. The final maturities are some way off for most Brady bonds, but the grace periods of lower interest payments have mostly ended. The Brady bonds’ unique structure— in which interest payments on outstanding bonds increase as the grace period, typically six years, expires—is causing difficulties now for sovereigns that are still following imprudent economic and financial policies. These growing interest payments, combined with external shocks, can push financially tottering sovereigns into default. As access to international capital markets has improved, emerging sovereigns have relied increasingly on new bond issues that, unlike Brady bonds, do not involve restructuring of past liabilities. But the maturity structure of newly issued global bonds has also changed in recent years. In the mid-1990s, bond issuance was concentrated in instruments with long-term maturities (20–30 years), which were used primarily to swap out of previously issued higher cost Brady bonds. Some maturities were even longer; for example, a 100-year Chilean energy conglomerate bond was offered to investors. Current emerging market foreign currency bond issues generally have intermediate-term maturities (5–20 years). Intermediate-term borrowing reflects the aversion of international investors to extending credit for lengthy periods. One of the reasons for their reticence is the risk of currency fluctuations, which can impede the ability of the sovereign to service the bonds. Many countries have moved from pegged or quasi-pegged exchange rates in the last two years to more flexible exchange rates. Currency volatility is a natural accompaniment to floating exchange rates and can affect the cost of debt to sovereign issuers. The change from loans to bonds and the introduction of variety in types of bonds have made countries more susceptible to investor sentiment than they were in the past. Market access may now be a key factor in a sovereign’s ability to finance fiscal deficits, and the benefits of financing in the global debt markets should encourage sovereign governments to maintain their access to the markets by pursuing prudent economic and political policies. Access to the debt markets is heavily influenced by international interest rates, commodity prices (especially for those countries that are heavily dependent on exports of primary products), the sovereign’s debt-service record, and the sovereign’s currency regime (stable or volatile). For example, Argentina, which has an extremely high debt-service burden and is the heaviest sovereign borrower among the emerging markets, introduced a currency board in
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Can Sovereign Defaults Be Forecasted? 1991 as a monetary anchor to control prices. As a result, the Argentine peso has a fixed exchange rate with the U.S. dollar. Although the currency board is seen by some as a liability that encourages excess external debt accumulation, investors believe that Argentina is committed to keeping the currency board, and they are encouraged by the stability provided by the Argentine currency reforms in terms of assessing the risk-adjusted return to holding Argentine debt. Sovereign External-Debt Profile. The debt profile (public versus private and long term versus short term) of developing countries changed between 1992 and 2000. As shown in Figure 2, the indebtedness of the three key emerging market regions—Latin Amer-
ica, emerging Asia (Australasia excluding Japan and Australia), and eastern Europe—has gradually shifted away from the public sector to the private sector. Privatization has been the key influence; public-sector agencies converted into private companies. Nevertheless, sovereign governments remain the primary issuers of debt in these countries. The majority of outstanding emerging market debt, public and private, has intermediate- to longterm maturities. As the debt matures, however, and the average maturity of the outstanding debt is shortened, service costs grow increasingly onerous for many emerging market countries. Figure 3 illustrates this maturing debt by charting the effective maturity dates for Latin American, emerging Asian, and
Figure 2. Public Intermediate- and Long-Term External Debt: Emerging Market Regions, 1992–2000 Percent of Total Debt 100 80 60 40 20 0 1992–96
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Figure 3. Effective Maturity of Intermediate- and Long-Term External Debt: Emerging Market Regions, 1992–2000 Effective Maturity (years) 20
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Global Bond Management II eastern European external debt from 1992 to 2000. The greatest drop in effective maturity has occurred in eastern Europe. The effect of increasing amounts of maturing debt—larger principal and interest payments due on an annual basis—is especially burdensome for Latin America, as Figure 4 indicates, although the trend is improving. The relatively higher debt-service burden in Latin America is a result of the restructured (Brady) debt, some of which will be subject to higher coupon payments as the debt approaches maturity. Compounding the problem is that the debt issued in the early 1990s, which was issued with shorter maturities than the debt of the mid-1990s, is now also beginning to mature. Another factor that has heightened the debtservice burden is the lack of growth in most emerging market countries. Many of these nations are struggling to stimulate growth and are experiencing low export levels, slow private-sector profit growth, and consequently, insufficient tax revenues. All of these phenomena negatively affect domestic savings, forcing the countries to increase dependence on external finance. Thus, inadequate growth produces a vicious circle in the financial and economic systems of emerging market countries and is a major hindrance to their successful future debt servicing. Short-term debt payments are also a potentially serious issue for emerging market governments, even though short-term liabilities are generally a low percentage of total external debt. Short-term liabilities can absorb a large share of sovereign reserve positions in any given year if no other source is available to meet the obligation. As Figure 5 shows, when total debt service is considered, all or nearly all of the sovereign
reserve positions would be wiped out if reserves were the only source available to prevent default. Therefore, keeping access to global capital markets open and strengthening the domestic economy is of critical importance to the emerging market governments. If these goals can be accomplished, fresh money will generally be available to service debt and the countries can avoid total reliance on reserves.
New Challenges The EIU in London has identified six areas driving the need for improvements in sovereign debt risk analysis: • globalization, • regionalism, • financial market innovations, • changing emerging market economies, • changing emerging market sovereigns, and • the changing role of multilateral agencies. These areas of political and financial evolution present a challenge for the sovereign and the analyst evaluating the sovereign’s debt risk. Globalization. Like the rest of the world, emerging market countries are exposed and vulnerable to events outside their borders. This external event risk must be explicitly recognized in models that are created to quantify sovereign risk. On the one hand, recent deregulation of the global markets—opening to trade and investment—has been quite positive for emerging market economies. On the other hand, capital controls have been imposed in some countries,
Figure 4. Debt-Service Ratios: Emerging Market Regions, 1992–2000 Debt-Service Ratio (% due) 40
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Can Sovereign Defaults Be Forecasted? Figure 5. Short-Term External Debt/Reserves: Emerging Market Regions, 1992–2000 Short-Term Debt/Reserves (%) 100 80 60 40 20 0 1992–96
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such as Malaysia, and these controls have found grudging favor with some market participants. At this juncture, whether capital controls will grow in popularity is not apparent, but the degree of regulatory freedom in global exchanges has important implications for both creditors and sovereigns in their respective roles of credit providers and credit seekers. Although information and data availability have improved in the developing countries, much of public and private reporting is not standardized. Thus, cross-country analysis is difficult to do. The abundant and constantly changing universe of information raises questions about the availability, timeliness, and frequency of sovereign debt risk analysis. What are appropriate procedures for updating and reevaluating sovereign credit risk in view of new information? The types of information and data covered also need to be expanded. Certain countries—in particular, China, Brazil, Indonesia, India, and Russia—have traditionally been considered outside the international industrialized country system but are now big players in the global arena. Their internal crises make front-page news and can threaten global financial stability. Therefore, analysts must be proactive in covering these increasingly important market movers, not only in a domestic context but also as an integral part of the global environment in which reciprocal links connect all international market participants. Regionalis m. In the 1990s, developing countries have been defined largely by region and shared regional characteristics. Emerging Asia, eastern Europe, and Latin America are the three primary regional groups. Intraregional relationships have been key factors in assessing sovereign global trade
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positions in terms of export capacity, trade bloc participation, and World Trade Organization negotiations. Cities such as São Paulo (Brazil) and Hong Kong (China) may develop further into regional capital centers, not only serving as financial centers for the regions but also dominating the regions politically and economically. The move toward regionalization may be a short-term phenomenon or a new paradigm; the direction is unclear. Financial Market Innovations. Sovereigns have several financing options: They can decide the currency in which the debt will be denominated and choose whether the targeted creditor base will be domestic or foreign. All of these factors affect the analysis of debt risk. The domestic capital base has been strengthened in many emerging economies, which has given most emerging market governments the ability to tap a certain amount of domestic capital. Foreign investors, however, are often a less expensive and more flexible financing source. Sovereign debt risk analysis also must take into account innovations in the international environment. Hedge funds, pension funds, and new forms of investment funds are participating in the developing country markets. These new investors require innovative risk analysis. In the future, the mandates of an international regulatory body, or bodies, created to regulate global capital flows may also need to be incorporated in sovereign debt risk analysis. Changing Emerging Market Economies. As the economies of emerging market countries shift from public to private domination, the sources of risk in their economies can be expected to shift. For those economies in which the private sector prevails, as in
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Global Bond Management II emerging Asia or the developed nations, private industry should receive significant weight in the assessment of sovereign debt risk. In a severe crisis, the sovereign might be called upon to become the ultimate guarantor of private-sector debt. Therefore, credit risk reports should identify key players in the sovereign’s banking and corporate sectors and assess their financial health to determine the private sector’s potential impact on country risk. Changing Emerging Market Sovereigns. As an issuer, the sovereign has several financing choices in terms of markets, instruments, and the instruments’ terms and conditions. These multiple possibilities complicate the analysis of credit risk. For example, what are the sovereign’s policies regarding foreign investment, competition, trade and exchange controls, and banking regulation? How consistently have these policies been enforced? How likely is the sovereign to change the rules of the game? And because the sovereign is the lender of last resort, how prepared is the sovereign to service the liabilities of any sovereign-guaranteed private-sector debt without negatively affecting the government’s ability to service outstanding sovereign debt? Changing Role of Multilaterals. The role of multilateral agencies, such as the IMF, must be considered in sovereign debt risk analysis. These agencies are being called to a more proactive, rather than reactive, role that will require enhanced monitoring of emerging markets and economies and improved international data standards. Some are calling for the IMF to develop a sovereign rating system. Such a system, however, would create a conflict of interest for the agency which also acts as a creditor to the emerging markets. Some are calling for “burden sharing,” whereby private creditors would be made to share the costs of any default with the official creditor. A test case of these new arrangements may be Ecuador, which is attempting to renegotiate its bond debt with private creditors. The analyst community must consider how strongly these concepts will be advocated and what their implications are for emerging market issuers.
Recommendations for Sovereign Risk Reports In light of the challenges outlined, the EIU recommends the following analytical guidelines for sovereign risk reports. Globalization. Sovereign debt risk analysts need to conduct quantitative assessments of the potential impact of globalization on the sovereign. Qualitative assessments and explicit identification of
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the sources of internal and external contagion are also needed to alert analysts to changes that threaten the sovereign’s financial solvency. Sovereign risk reports should contain a specific qualitative assessment of the degree of openness in the economy allowed by regulations. If the economy is open, what is the potential that the government will shift the regulatory regime? Are major regulatory changes looming on the horizon? The sovereign may be influenced by a regional or international regulatory environment in addition to the domestic environment. Both international and regional regulatory changes can seriously affect the banking and corporate sectors of the sovereign’s economy. The report needs to focus on these environments also. Because global events shake the economies of the world now more than ever, country risk reports are increasingly sensitive to time, information, and assumption. Sole reliance on international sources is not sufficient for the fast pace of global change, even though cross-country comparability is enhanced through an international database. Fortunately, local information, which is crucial to risk analysis and reporting, has improved in availability and timeliness—thanks in part to data standards released and championed by the IMF following the 1994–95 Mexican liquidity crisis. An increase in reporting frequency, particularly electronic reporting, and an increase in event-driven reporting are also necessary responses to constantly realigning global relationships. Stating the global assumptions on which the country report’s conclusions are based is imperative. For example, if an analyst who is reporting on Argentina, Brazil, or Indonesia expects a U.S. Federal Reserve rate hike, the analyst must clearly state that assumption in the country report. The assumption would imply higher U.S. interest rates and a consequent negative impact on these countries, which have a large portion of their external debt denominated in U.S. dollars. Regionalism. Regionalization, in terms of trade flows and investor perceptions, mandates that sovereign debt risk reports no longer focus solely on the sovereign but incorporate the regional environment. Often, investors allocate capital to a region rather than a specific country or industry first. A discussion of the key regional players should also be an integral part of the country report. What is the potential for regional contagion if a key player alters its political, economic, or regulatory course? What would be the effect on other sovereigns? This is clearly an important issue: Brazil’s devaluation in January 1999 had a strong impact on Argentina, pushing the latter into recession.
©2000, Association for Investment Management and Research
Can Sovereign Defaults Be Forecasted? Financial Market Innovations. As the number of financing alternatives grows, potential debtservicing complications multiply. Discussion of the sovereign’s financing choices— such as the maturity of the debt, the currency in which the debt is denominated, and the total outstanding debt burden— should be explicitly stated in the country report by the sovereign debt risk analyst. In general, sovereign debt risk analysts need better financial training. Analysts tend to come from a political, international relations, or economics background; thus, their understanding of financial markets is often limited. Financial market issues should be analyzed in more detail than is currently found in most country risk reports. Also, an analysis of the links between the sovereign’s financial markets and political processes with those at the global level is necessary for a complete country report. Changing Emerging Market Economies. The EIU’s recommendations regarding the reporting on emerging market economies focus on two areas of analysis: the importance of a strengthening private sector and the degree of international financial integration. The private-sector analysis can be performed by first identifying the key corporate/bank players. When private industry has developed sufficiently to dominate the public sector, corporate risk analysis of the key players and the implications for the sovereign’s ability to meet debt-service requirements is in order. The degree of international financial integration of the sovereign can be uncovered by an examination of the global links affecting the sovereign, the level of sophistication of local and international financial transactions, and a thorough analysis of current and expected monetary policy.
Changing Role of Multilaterals. In the past, conflicting information from multilateral agencies has hampered the process of sovereign debt risk analysis, particularly cross-country comparisons. To correct this problem, the multilateral agencies need to more closely coordinate the collection and dissemination of data on global money and trade flows. The IMF and World Bank have initiated an effort to accomplish this goal, which should bear fruit in several years. An entirely new system of measures and data presentation can be expected to emerge from this coordination process. Improvement in country reporting can easily be accomplished by focusing on the sovereign’s role in its region and the world, with an emphasis on the reciprocal links in the global economy that affect the sovereign and the consideration of the impact of a strengthening private sector and of any contingent liabilities of the private sector on the total debt burden of the sovereign. New Quantitative Parameters Needed. Many different measures can objectively quantify the financial health or potential for financial deterioration of a sovereign, and these quantitative parameters should be an integral part of sovereign debt risk analysis. Exhibit 1 lists several valuable measures, but creation of a standard set of relevant parameters is very much a work in progress. One of the more important quantitative measures is the acknowledgment that private industry
Exhibit 1. New Quantitative Parameters Domestic credit/GDP growth Real deposit growth M2 multiplier (×)
Changing Emerging Market Sovereigns. In general, this topic is handled well in country reporting at present. The major rating agencies conduct cross-country spread analyses and extend the rating analyses to encompass countries in similar circumstances. Rating agencies are examining, as they should, the term structures of debt, amortization schedules, and total debt burdens of the sovereigns. To analyze the regulatory environment and the impact of regulatory changes on the sovereign’s public and private sectors, rating agencies are now discussing regulatory risk in their reporting. And in order to correctly assess the sovereign’s vulnerability as the lender of last resort, the agencies now include in most country risk reports an estimate of the debt service associated with the sovereign’s contingent liabilities and off-balance-sheet liabilities.
Real sovereign spreads Real interest rates Commercial banks’ net foreign assets (USD) Other asset prices, especially property changes Non-trade-related inflation (% of total inflation) Productivity growth Short-term debt/Reserves Foreign direct investment financing requirement Potential debt servicea /Exports or reserves BIS short-term debtb/Local-source short-term debt (USD millions)c Debt service/GDP Terms of trade Export dependence aPotential debt service = Medium-long-term principal repayments + Short-term debt stock. b Bank for International Settlements. cComparative measure; if large discrepancy, investigate.
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Global Bond Management II risk as a component of country risk is a primary influence on sovereign debt risk. Another major consideration is quantification of the potential for capital flight away from the sovereign’s economy. A comparison of country interest rates in real terms and the yield spreads on external bonds as well also needs to be quantified in the reporting process. Unfortunately, net foreign asset/liability positions of commercial banks are frequently omitted from country risk reports. These positions can divulge important information to alert analysts. For example, such positions would have been particularly pertinent to analysts covering Asia in the mid1990s as more and more Asian banks began to borrow heavily abroad. Eventually, many of those banks ran into great difficulties in repaying their foreign loans. Not only were many of the Asian banks’ domestic corporate borrowers stung by the effects of the Asian crisis and unable to make timely payments on their obligations to the Asian banks, but currency devaluations also hampered the Asian banks’ abilities to repay their overseas obligations. Also, matching short-term assets and liabilities is crucial. The Bank for International Settlements does an excellent job of reporting this information. Frequently, consumer prices alone do not provide sufficient information for a thorough analysis of price levels and the future direction of inflation and interest rates. Therefore, other asset prices should be included in the analysis of inflation as indicators of the risk of a boom or bust situation developing. A measure of the degree to which consumer prices are trade related (import prices do not remain static) also has meaningful implications for a sovereign’s fiscal policy. Another potential quantitative parameter that can be useful in sovereign debt analysis is a measure of productivity growth to determine whether a certain exchange rate is sustainable. In addition, a mea-
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sure of a country’s export dependency would be helpful, particularly in view of the effect commodity prices have on the exports and resulting economic condition of the sovereign. These quantitative measures can be subjectively interpreted to add to the analyst’s understanding of the weaknesses and strengths hidden in the sovereign’s economy. As the web of global interconnectedness among countries, private-sector corporations, financial markets, international regulators, and investors expands, any and all sources of information should be exploited by the sovereign debt risk analyst for the most accurate assessments possible.
Conclusion Future reports on sovereign debt risk analysis will probably differ from the ones that exist today. The country risk reports will be shorter and will occur with greater frequency, and they will contain more analysis and less reporting. The reporting will instead be done by the wire services. Analysis will be set in historical, regional, and global contexts to provide a complete understanding of events. The future reports will contain more cross-country comparisons derived from newly developed quantitative parameters. Another difference will be a deeper integration of global financial market developments with sovereign debt risk and a broader definition of sovereign liabilities. Even with these improvements in reporting and analysis, however, sovereign debt risk analysis will remain a difficult process because of the myriad global financial links and rapid economic changes occurring in the world today. In all likelihood, the sovereign debt risk analyst will still be unable to forecast sovereign default, but the information presented to investors will be vastly more useful in the future than in the present.
©2000, Association for Investment Management and Research
Can Sovereign Defaults Be Forecasted?
Question and Answer Session David Anthony Question: How do you deal with a situation in which data come out with long lags and the sources are suspect? Anthony: Dealing with such problems is difficult, but with long information lags, proxies are helpful. Sometimes, the proxies have to be innovative. In trying to do some risk work in Surinam, for example, we found that the country’s data on output and external balance tend to come out with a long time lag. The IMF, however, tends to have good monetary data on international reserves, financial system liabilities and assets, and prices. By using these parameters as proxies, we were able to make inferences as to what might be happening in the Surinam economy. For example, we determined that real credit growth was about 125 percent and reserves were stable. We knew the country risk factors. The country had a lot of gold that was placed in reserves and then changed into hard currency to back a fixed exchange rate in order to anchor prices and stabilize a hyperinflationary economy. The massive reserve growth was feeding into liquidity; everything pointed to a boom in consumption. This was backed by stories of massive spending and the rapid growth of pyramid schemes. The situation did not appear sustainable, however, because the price of Surinam’s largest exports, gold and other base metals, was falling, political uncertainty was high, and the economy was still mismanaged. These factors were not debt related, and we didn’t have the trade or capital account parts of the picture in Surinam, but we could imagine that the current account was probably entering very nega-
tive territory: New money was not flowing in, only reserves accumulated through gold, and consumption was out of control. All signs pointed to an impending problem. In fact, the situation I have just described occurred in late 1996 and early 1997, and Surinam has since devalued. Being innovative with proxies can be beneficial when the standard data do not provide all the answers. If the sources of data are suspect, an analyst can only indicate doubt about the data source in the country report and attempt to develop local information sources for aid in assessing the degree of truth in published data.
ethnic struggles outweigh such factors. Most analysts recognize potential areas of conflict or even politically invested interest groups. For example, in Bolivia, the indigenous community is taking the government to court and winning cases. Groups of people claiming back the land or obtaining compensation for land could have a great impact on risk analysis. In Indonesia, the economic crisis has led to demographic fragmentation as island and ethnic allegiances take precedence over nationality and unity.
Question: What role, if any, do demographics play in sovereign debt risk analysis?
Question: Are the developed countries today sowing the seeds for a crisis similar to those of the 1980s by lending aggressively to developing countries in the public markets?
Anthony: Knowing the demographics of a developed country— income distribution, per capita GDP, the labor market, population aging, and so on—is useful for looking at the long-term opportunities for investment or growth in the country. The emerging market economies, however, are at a different stage of development, and as a result, demographics are not a key risk factor there. In emerging markets, capital inflows go to a small part of the economy, the sectors that are attractive to investors. A demographic profile considers the wider, informal economy. Ethnic struggles are the most prevalent demographic factor in risk analysis of emerging economies at the present time. Most emerging markets, other than in Asia, still have a youthful population, and although population growth and urbanization are important demographic trends,
Anthony: Some would argue that the developed countries are sowing the seeds for a similar crisis. Investors from the industrialized or developed countries should be much more skeptical than they are about investing in the emerging markets. If you compare the returns on the S&P 500 Index with those of emerging markets, you can see that you might as well keep your money in the United States. If you really believe that a country is committed to meeting its obligations, and there are certain countries that are, you may make a quick buck, but it is a risky venture overall. Prudence on the part of individual investors about emerging market investing will reduce the likelihood of a 1980stype crisis. Growth and price stability can mask a host of underlying problems. For example, the reports might forecast that next year
©2000, Association for Investment Management and Research
41
Global Bond Management II emerging Asia will grow at 6 percent, Latin America will rebound at 4 percent, and eastern Europe will grow at 4 percent. And everything may move in this direction—until a crisis occurs. In Mexico, Thailand, and Russia—all the countries that have been in currency crises in the last few years—their debt profiles all worsened markedly. In the case of some of the Asian countries, their external debt/GDP ratios were about 30 percent, and now they’ve gone toward 50–60 percent, which are approaching Latin American levels. This rise may not be a problem right now, but it could
42
become a problem in the future. Many countries—those in Latin America, for example—cannot rid themselves of the negative effects of “debt overhang.” They are locked into a vicious circle of seeking external financing to finance internal growth while battling the potential inability to borrow because of an increasing debt burden associated with a dependence on borrowing. If these countries have above-trend growth for a few years, all appears fine, but the underlying weakness is never eliminated.
Another factor to consider is the amount of direct and contingent liabilities for which a sovereign is liable. This factor is important because of the shift toward the private sector and the sovereign’s role as the lender of last resort. The Asian crisis illustrated that the financial health of a country depends on the health of its internal economic components as well as its role in the global economy. The public and private sectors are increasingly codependent. As a result, sovereign debt risk analysis must incorporate an analysis of the private sector.
©2000, Association for Investment Management and Research
Global Bond Benchmarks Lev Dynkin Managing Director Lehman Brothers
The increase in out-of-index global investing has clearly shown the need for more inclusive global indexes. Lehman Brothers is thus producing two new and broader market-capitalization-weighted fixed-income global indexes—one that captures the world U.S.-dollar-denominated opportunity set and one that, when final, will reflect the entire (U.S. dollar and non-U.S. dollar) global investment-grade opportunity set.
oday is an exciting time in the world of indexes. Investors are stretching the envelope in terms of mandates that reach beyond the realm of standard benchmarks. The challenge is to create indexes and benchmarks that reflect this investor-driven trend. Broad standards are needed as new asset classes are created by issuers and accepted by investors. In response to investor demand, Lehman Brothers has been devoting much time and effort to the development of two macro indexes (indexes that combine asset-class indexes)—the U.S.-DollarDenominated Universal Index and the Global Aggregate Index. This presentation first focuses on the U.S. Universal, which has already gained acceptance from the investor community. The final part of the presentation describes the Global Aggregate, which represents our quest for mapping out the global opportunity set by combining all investment-grade fixed-income asset classes into a single benchmark.
T
Introduction to the Macro Indexes In its role as a provider of bond market index information to the investment community, Lehman Brothers has developed an entire family of indexes. An overview is given in Figure 1. As shown in the figure, the U.S. Universal is a conglomeration of all Lehman U.S.-dollar-denominated indexes. It is the focus of this discussion. Editor’s note: Lev Dynkin supplied information to update his presentation as of July 2000. The joint Question and Answer Session of Mr. Dynkin, Peter Rappoport, and T. Jon Williams follows Mr. Rappoport’s presentation.
The Global Aggregate consists of the U.S. Aggregate, the Pan-European, the Asian-Pacific Aggregate, and Canadian Treasuries. The U.S. Aggregate, the dominant index in its class, is already a macro index because it consists of subindexes in the various U.S. bond asset classes—U.S. Treasuries, U.S. agency bonds, corporate bonds, and mortgage-backed and asset-backed securities. On January 1, 1999, the Euro-Aggregate Index was launched to include government and corporate subindexes of euro-denominated instruments. The Euro-Aggregate Index mimics the U.S. Aggregate, in that it consists of investment-grade governments, corporates, and collateralized securities. The PanEuropean Index combines the Euro-Aggregate with investment-grade fixed-income securities denominated in European currencies other than the euro. Most of the component subindexes of the AsianPacific Index are not finished yet, but once we have all the components of the aggregate indexes for the United States, Europe, and Asia, the Global Aggregate will be complete. It will represent the total opportunity set open to investment-grade portfolio managers.1 The Global High Yield Index, also following the globalization route, combines the U.S. High Yield Index—dating from July 1982—with the European High Yield and the Emerging Markets indexes. Like any other multicurrency index, the Global High Yield Index can produce returns in U.S. dollars, euros, or any other basis currency. 1 The
Asian-Pacific Index was launched as a stand-alone index on July 1, 2000, and will be incorporated into the Global Aggregate Index on October 1, 2000.
©2000, Association for Investment Management and Research
43
Global Aggregate
U.S. Aggregate
U.S. Treasury
©1999, Association for Investment Management and Research
U.S. Agency U.S. Investment Grade Corporates
MBS
ABS
Global High Yield
Pan-European
EuroAggregate
U.S. High Yield
Non-U.S./Euro
Non-European Monetary Union
AsianAggregate
NonAsian
Euro High Yield
U.S.-DollarDenominated Universal
Other
Municipals
Corporates
Collateralized
Governments
144-(a)
CMOs
Reals
Corporate Loan
ARMS
Global Sovereign
Eurodollar
CMBS
Private Placement
ABS Floaters
Emerging Markets Euro Government
U.K.
Asian Government
Canada Dollar
Euro Corporate
Euro Collateralized
Others
Asian Corporate
Asian Collateralized
Others Non-Dollar
Corporate Floaters
U.S.
Euro
Note: ABS = asset-backed securities; ARMS = adjustable-rate mortgage securities; CMOs = collateralized mortgage obligations; CMBS = commercial mortgage-backed securities; Reals = inflation-protected securities; 144(a) = the index of Rule 144(a) private placements.
Global Bond Management II
44
Figure 1. Lehman Brothers Global Family of Indexes as of January 1, 1999
Global Bond Benchmarks
Motivation for Macro Indexes Macro indexes are not new. In the past, such indexes simply evolved—not by design but through use by investors and consultants. At some point in the mid1980s, for example, our government and corporate indexes were combined to form the Lehman Government/Corporate Index, which for a while was our most popular index in the fixed-income market. Later, when mortgages and asset-backed securities were added to the Government/Corporate Index, this new index, the U.S. Aggregate, preempted the Government/Corporate to become the most popular index for U.S. fixed-income portfolios. The trend toward globalization in indexes and the formation of macro indexes begins when investors expand their universes to buy securities outside their index or benchmark of choice; in other words, investors start to invest in out-of-index investments. This phenomenon is a response to the never-ending search for global alpha. Today, out-of-index investments might include securities in emerging markets, high-yield bonds, or Rule 144(a) private placements. Investors add out-of-index securities to benefit from additional diversification. The newer asset classes have risk characteristics that give them low, or sometimes negative, correlations with asset classes already in the benchmark index. Lowering risk through low correlation of assets is one of the main benefits of diversification. The U.S. Universal especially reflects these benefits. A problem arises when the use of out-of-index securities or out-of-index asset classes becomes persistent. The performance of a portfolio will not be measured fairly if it is benchmarked against an index that does not fully represent the security set held in the portfolio. Ideally, a portfolio measured against a particular index should limit its assets to those included in the index. This premise has always been the basis of Lehman’s approach to index formation. In addition, our view has been that indexes should be based on market-capitalization weights. The reason for using market weights is that investor accessibility to securities is often proportional to market value. So, the ideal investor portfolio would select securities only from the index set and would pursue superior performance by over- or underweighting sectors within the set and through yield-curve bets. To the extent that consultants observe this trend of investing in out-of-index securities (a core-plus strategy), they will guide benchmark selection to reflect the entire opportunity set represented in portfolios. In other words, portfolios that invest today on a hedged basis into some non-U.S.-dollardenominated securities versus the U.S. Aggregate (which would be the core) will eventually be mea-
sured against the Global Aggregate. Portfolios that are invested in emerging market and high-yield securities and that are measured against the U.S. Aggregate will eventually be measured against the U.S. Universal so that the opportunity set and the portfolio security set will be better matched. A macro index is more convenient to a portfolio manager than following a core-plus strategy when the manager wants to pursue a negative view on an asset class. The macro index allows the manager to simply underweight the out-of-favor class. For example, if the manager has a negative view on emerging markets and is benchmarked to the U.S. Aggregate, the only strategy the manager can take to pursue a negative view on emerging markets is not to buy them. But if the manager is benchmarked to the U.S. Universal, which has a 3.36 percent weighting in emerging markets, the manager can simply underweight the sector by investing, say, 2 percent in emerging markets.
U.S. Universal Index We created the U.S. Universal by combining all available U.S.-dollar-denominated, fixed-rate indexes. We put these together by market-cap weights and found that the combination exhibited some attractive historical properties. Composition. The composition of the U.S. Universal is presented in Table 1. The U.S. Aggregate makes up 84.46 percent of the Universal; investmentgrade additions and high-yield additions make much smaller contributions. Our CMBS (commercial mortgage-backed securities) Index only goes back two years, so an example of the Universal extending back five years would lack the CMBS. The high-yield CMBS and investment-grade CMBS components are only small parts of the Universal, however, so their impact on the overall performance of the Universal is negligible. The benefits of diversification in the U.S. Universal as compared with the U.S. Aggregate are illustrated in Table 2, which contains the correlations of subindex excess (curve-adjusted) returns from the end of January 1995 to the end of September 1999. (Curve-adjusted returns are calculated by subtracting the security’s return from the return of a durationmatched U.S. Treasury security. If the return is positive, then the asset class has outperformed Treasuries of like duration.) The correlations with other subindexes are predictably lower for the emerging market and U.S. high-yield sectors. So, the Universal should provide diversification benefits beyond what the U.S. Aggregate can provide. The U.S. Universal has a wider distribution of credit quality than the U.S. Aggregate. The quality
©2000, Association for Investment Management and Research
45
Global Bond Management II Table 1. Composition of U.S. Universal Index, September 30, 1999 Market Value (USD millions)
Sector U.S. Universal U.S. Aggregate U.S. Treasury
Percent of Sector
Percent of Index
6,431,798
100.00
5,432,253
100.0
84.46
1,843,624
33.9
28.70
Agencies
470,378
8.7
7.30
Industrials
485,122
8.9
7.50
80,587
1.5
1.30
326,195
6.0
5.10
Utilities Financials Yankees MBS
244,369
4.5
3.80
1,836,238
33.8
28.50
ABS and ERISA CMBS
145,741
2.7
2.30
Investment grade additions
446,024
100.0
6.93
Eurodollar (ex-Aggregate)
315,044
70.6
4.90
144-(a)
95,755
21.5
1.50
Emerging Markets (investment grade, ex-Aggregate)
16,594
3.7
0.26
Non-ERISA CMBS
18,631
4.2
0.29
High-yield additions
553,520
100.0
8.61
U.S. High Yield
348,370
62.9
5.40
Emerging Markets
198,359
35.8
3.10
High-Yield CMBS
6,791
1.2
0.11
Table 2. U.S. Universal: Correlation of Subindex Excess Returns, January 1995–September 1999
U.S. Aggregate
U.S. Aggregate
U.S. High Yield
144-(a)a
Emerging Markets (ex-Aggregate)
1.000
0.762
0.938
0.524
1.000
0.912
0.653
1.000
0.723
U.S. High Yield 144-(a) Emerging Markets (ex-Aggregate) aSince
1.000
December 31, 1997.
distribution of the Universal is compared with that of the U.S. Aggregate as of September 30, 1999, in Table 3. Aaa debt represents about 10 percentage points less in the Universal than it does in the U.S. Aggregate. The total market value of Aaa and Aaa+ debt in both indexes has gradually dropped in the last several years because of the reduction in U.S. Treasury issuance. Declining U.S. Treasury issuance has also contributed to a gradual rise in the proportion of non-U.S. issuers in the U.S. Universal over the past several years. This rise can also be attributed to a growing Yankee sector (U.S.-dollar-denominated bonds of foreign-domiciled issuers) and increasing emerging market bond issuance.
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Table 3. Quality Distribution: U.S. Universal and U.S. Aggregate, September 30, 1999 Rating
U.S. Aggregate
U.S. Universal
Aaa
80.35%
70.31%
Aa
4.10
5.64
A
9.23
9.08
Baa
6.32
6.46
Ba
0.00
3.57
B
0.00
3.87
Caa
0.00
0.54
Ca–D
0.00
0.11
NR Total
0.00
0.42
100.00%
100.00%
Note: NR = not rated.
©2000, Association for Investment Management and Research
Global Bond Benchmarks Return and Risk. Returns to the U.S. Universal have been only slightly better than returns to the U.S. Aggregate. The historical returns of the Universal and U.S. Aggregate indexes are compared in Table 4 for the almost five years from 1995 through late 1999. The Universal’s annualized cumulative return of 8.21 percent from 1995 to 1999 is slightly better than the U.S. Aggregate’s 8.18 percent. The Universal underperformed the U.S. Aggregate significantly in 1998, but its outperformance in the other four years was sufficient for the Universal to end the period ahead of the U.S. Aggregate. Table 4 also shows that the standard deviation of annual returns for the U.S. Universal was predictably lower than that of the U.S. Aggregate—5.66 percent versus 5.85 percent—as a result of the low correlations of the newly introduced emerging market and highyield sectors with the established U.S. Aggregate component. The ratio of average annual return to standard deviation for the five years for the Universal was found to be 1.48 return per unit of risk, somewhat of an improvement on the same measure for the U.S. Aggregate, which was found to be 1.44 return per unit of risk. This favorable comparison indicates that the Universal delivers more return per unit of risk than the U.S. Aggregate, which is a pleasant surprise because achieving optimality was not our objective and is not usually an index goal. Our objective was to reflect the opportunity set of the core-plus strategy being implemented by investors. A comparison of returns for both indexes on a monthly basis over the same five-year period confirms the outcome of the analysis of average annual returns. Again, a small improvement in the return per unit of risk was achieved by the U.S. Universal over the U.S. Aggregate return—2.16 percent versus 2.10 percent. And a comparison of the monthly standard deviations of return for the same period, presented
in Table 5, shows that the standard deviation for the Universal was lower each year than the standard deviation for the U.S. Aggregate. The positive attributes of the U.S. Universal are even more pronounced when the monthly excess (curve-adjusted) returns presented in Table 6 are considered. The annualized average excess return of the Universal was found to be 0.26 percent versus 0.07 percent for the U.S. Aggregate. The annualized average excess return per unit of risk (per annualized standard deviation) for the period was 0.25 for the Universal versus 0.10 for the U.S. Aggregate. Duration, Yield, and Curve Sensitivity. Other comparisons between the two indexes made for the period from January 1995 through September 1999 include analyses of comparative duration, yield, and curve sensitivity. By all measures, the U.S. Universal compares favorably with the U.S. Aggregate. The Universal has a shorter duration than the U.S. Aggregate while providing higher yields and spreads. As shown in Table 7, this superiority is true regardless of which statistics one looks at—average, median, maximum, or minimum values. The return on the U.S. Universal was less sensitive than that of the U.S. Aggregate to variations in the return of the five-year Treasury note and the Lehman Treasury Index. Table 8 illustrates the empirical sensitivities of each index to the five-year T-note. Summary. The U.S. Universal provides a benchmark that encompasses an opportunity set similar to the sets already adopted in practice by many portfolio managers as they pursue core-plus strategies versus core-alone strategies (e.g., benchmarked to the U.S. Aggregate Index). The Universal provides greater diversification, higher return per unit of risk, shorter
Table 4. Annual Returns: U.S. Universal and U.S. Aggregate, January 1995–September 1999 U.S. Universal
U.S. Aggregate
Difference (Universal minus Aggregate)
1995
18.48%
18.48%
0.00
1996
4.45
3.63
0.82
1997
9.77
9.65
0.12
1998
7.30
8.69
–1.38 0.48
Year/Measure Annual return
–0.22
–0.70
Annualized cumulative return
1999 (to 9/99)
8.21
8.18
0.02
Average annual return
8.39
8.40
–0.02
Standard deviation
5.66
5.85
–0.19
Average return/Standard deviation
1.48
1.44
0.05
©2000, Association for Investment Management and Research
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Global Bond Management II Table 5. Annual History of Standard Deviations of Monthly Returns: U.S. Universal and U.S. Aggregate, January 1995– September 1999
U.S. Aggregate
Difference (Universal minus Aggregate)
Year
U.S. Universal
1995
1.00%
1.01%
–0.02
1996
1.21
1.24
–0.03
1997
1.05
1.05
–0.01
1998
0.72
0.79
–0.06
1999
0.88
0.89
0.00
duration, and less sensitivity to movement of the Treasury curve. All of these benefits are achieved without significantly lowering credit quality or reach-
ing for higher spread durations. All in all, the Universal is a win-win proposition.
Global Aggregate Index The new Global Aggregate has not yet been completed as we envision it. At this time, the index is a combination of the U.S. Aggregate Index, the Pan-European Index, and the treasury debt of other investmentgrade markets—Japan, Canada, New Zealand, and Australia. The Global Aggregate will be finished once we have an Asian-Pacific Aggregate. When finalized, the index will represent the investment-grade opportunity set: government, corporate, collateralized, and mortgage-backed/asset-backed asset classes. The
Table 6. Monthly Excess Returns: U.S. Universal and U.S. Aggregate, January 1995–September 1999
Year/Measure
U.S. Universal
U.S. Aggregate
Difference (Universal minus Aggregate)
1995 Average (monthly)
0.04%
0.01%
0.03
Standard deviation (monthly)
0.13
0.11
0.02
Average (annualized)
0.47
0.08
0.39
Average (monthly)
0.11
0.04
0.07
Standard deviation (monthly)
0.11
0.05
0.06
Average (annualized)
1.34
0.47
0.87
Average (monthly)
0.05
0.03
0.02
Standard deviation (monthly)
0.17
0.09
0.08
Average (annualized)
0.58
0.31
0.27
–0.14
–0.06
–0.08
0.50
0.35
0.15
–1.64
–0.74
–0.90
Average (monthly)
0.06
0.02
0.03
Standard deviation (monthly)
0.28
0.22
0.06
Average (annualized)
0.68
0.28
0.40
Annualized average
0.26
0.07
0.19
Annualized standard deviation
0.98
0.67
0.31
Annualized average excess return/Annualized standard deviation
0.25
0.10
0.15
1996
1997
1998 Average (monthly) Standard deviation (monthly) Average (annualized) 1999
January 1995–September 1999
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©2000, Association for Investment Management and Research
Global Bond Benchmarks Table 7. Yield Analysis: U.S. Universal and U.S. Aggregate, January 1995–September 1999
Measure
U.S. Universal
U.S. Aggregate
Difference (Universal minus Aggregate)
Yield-to-worst minus yield on five-year Treasury note Average
1.19
0.79
0.40
Median
1.31
0.82
0.48
Maximum
1.92
1.35
0.57
Minimum
0.61
0.45
0.16
Current (September 1999)
1.50
0.99
0.51
Option-adjusted spread Average
0.67
0.34
0.33
Median
0.54
0.29
0.26
Maximum
1.31
0.73
0.58
Minimum
0.41
0.21
0.21
Current (September 1999)
1.10
0.58
0.52
result may be an information-only benchmark. At this point, the properties of the index are unknown.2 Composition. As of September 30, 1999, the U.S. Aggregate’s contribution to the Global Aggregate was 46.5 percent, but the contribution of the PanEuropean Index was not far behind at 41.3 percent. In the short term, this allocation is influenced most by fluctuations in the U.S. dollar/euro exchange rate.
Table 8. Empirical Sensitivities: Regression of Index Return on Return of Five-Year T-Note, January 1995–September 1999
Statistic
U.S. Universal
U.S. Aggregate
Difference (Universal minus Aggregate) –0.09
Slope estimate
0.77
0.86
Standard error
0.06
0.04
—
Intercept
0.20
0.14
0.06
Standard error
0.08
0.05
R2
78%
90%
— –12.00
The Pan-European is a European version of the U.S. Aggregate. Predictably, most of the PanEuropean Index securities are government bonds. Collateralized securities (primarily Pfandbriefe issued in Germany) are the second largest contributor to the 2 On June 30, 2000, Lehman Brothers launched the Asian-Pacific Index, which completed the Global Aggregate. Properties of the complete Global Aggregate Index are now well understood and were published in the “Global Aggregate Index” primer by Lehman Brothers in May 2000. The Asian-Pacific Index will start contributing to returns of the Global Aggregate in October 2000. The Global Aggregate has been adopted as a performance benchmark by a number of institutions.
Pan-European Index. The other components of the index are sovereign bonds (government bonds issued in foreign currencies) and supranational bonds (such as those issued by the International Bank for Reconstruction and Development, the Asian Development Bank, etc.) and a growing component of corporate bonds denominated in European currencies. The Pan-European Index is dominated by Aaa and Aaa+ securities, which constitute more than 90 percent of the index. Lower-quality securities—A and Baa credit ratings—make up only 9 percent of the total index. We expect, however, that as corporate issuance grows, the amount of lower quality securities in the index will quickly expand. Effect of Hedging. The currency component of the unhedged Global Aggregate dominates the index’s historical average annual returns and standard deviation of returns. Table 9 shows that the average annual unhedged return of the Global Aggregate from 1995 through 1999 was lower than the average annual return of the U.S. Aggregate for the same period. Also, the standard deviation of returns was higher, and the return per unit of risk was lower. Analysis of the monthly returns unhedged (from January 1995 through September 1999) produces the same results. This picture changes completely when the Global Aggregate is viewed on a hedged basis. A regression analysis of the return difference between the Global Aggregate and the U.S. Aggregate with currency return being the explanatory variable explained 90 percent of the return differential. With some simplification, the unhedged Global Aggregate can be viewed as basically a combination of the U.S. Aggregate and the foreign currency components of its nondollar part.
©2000, Association for Investment Management and Research
49
Global Bond Management II Table 9. Global Aggregate: Annual Return History, January 1995– September 1999 (unhedged)
Year/Measure
Global Aggregate
Difference (Global U.S. Aggregate minus Global Aggregate Aggregate U.S. Aggregate) Currency Return
Annual return 1995
19.66%
18.48%
1.18
1996
4.91
3.63
1.28
–1.65
1997
3.79
9.65
–5.86
–5.25
1998
13.71
8.69
5.02
3.89
1999
–3.65
–0.70
–2.95
–3.00
Annualized cumulative return
7.78
8.18
—
–0.98
Average annual return
8.28
8.40
–0.13
–0.76
Standard deviation
7.45
5.85
1.60
3.33
Average return/Standard deviation
1.11
1.44
–0.33
–0.23
When the Global Aggregate is considered in a hedged context, the characteristics of the index improve upon those of the Global Aggregate just as the U.S. Universal improves upon the U.S. Aggregate. The standard deviation of monthly returns for the Global Aggregate on a hedged basis was slightly less than that of the U.S. Aggregate, and the hedged returns reflected better diversification than the U.S. Aggregate. At this point, we do not know the return–risk characteristics of the final Global Aggregate, but our hope is that the diversification properties will be stronger than the unhedged Global Aggregate.
Conclusion To date, our mission to expand the Lehman Brothers family of fixed-income indexes to capture the true opportunity set of investment vehicles used by investors in fixed-income management has been successful. The U.S. Universal, a market-cap-weighted macro
50
1.63%
index comprising all U.S.-dollar-denominated fixedincome indexes that Lehman produces, has exhibited favorable risk–return characteristics when compared with the Lehman U.S. Aggregate. Already the new index is being used and accepted by investors as an important fixed-income benchmark. Finalizing the Lehman Global Aggregate—a macro index designed to represent the entire (U.S. dollar and non-U.S. dollar) global investment-grade opportunity set—is the next step. The last major components of this index will be the Asian-Pacific collateralized and corporate securities indexes. Whether the Global Aggregate will exhibit risk– return characteristics versus the U.S. Aggregate that are as favorable as the U.S. Universal versus the U.S. Aggregate is unclear at this stage, but in any event, the Global Aggregate should be a valuable information tool for the fixed-income investment community.
©2000, Association for Investment Management and Research
Global and Emerging Market Bond Benchmarks
Question and Answer Session Lev Dynkin Peter Rappoport T. Jon Williams, CFA1 Question: How can one deal with the lack of history for a portion of the Global Aggregate Index when assessing risk exposures and performing optimizations? Dynkin: Generally, when Lehman Brothers launches a new index, we try to complete the history as far back as prices permit. In the case of the Pan-European Index, especially its EMU component, that practice was not very useful because the history of the European corporates prior to EMU has little to do with their history post-EMU. This problem explains why we used only history from December 1998 to the present in calculating the standard deviation for the Global Aggregate Index. The lack of historical data is also a problem in developing risk models that use historical variances and correlations of factors in those markets. Some creative ways of dealing with this problem, however, have been developed. Many portfolio managers in Europe, for example, think that the euro corporates’ historical behavior can be imputed from the history of U.S. corporates, although the idea is debatable. How to fill in legitimate historical gaps—not ones for which we don’t have an index but gaps of time in which no market existed—is an issue that needs to be addressed on a case-by-case basis. 1T. Jon Williams, currently a director at InvestorForce.com (formerly Asset Strategy Consulting), joined Mr. Dynkin and Mr. Rappoport for this Question and Answer Session.
Question: Could you expand on what is wrong with an equally weighted index, such as an equal weight by country capitalization? Rappoport: There are simply not enough bonds issued and available in the market for investors to benchmark the full weighting if equal weights are used. For some of the smaller countries, the gap between capitalization (the amount of outstanding bond issuance) and the weight in such an index would be huge. The Ivory Coast, for example, is 0.1 percent in terms of capitalization. We have 27 countries, and under equal weighting, each weight would be about 3.5 percent. Then, somehow, portfolio managers would have to get 3.4 percent more in securities for the Ivory Coast than the country’s market cap. Such a trick would certainly be good for the price of Ivory Coast bonds, but it would not have any other merits. Question: Recent studies, some by J.P. Morgan & Company, argue that global portfolios should be invested against non-capweighted benchmarks and also have large (60–80 percent) nongovernment exposure. Will index providers or consultants be pushing these concepts? Williams: You need a capitalization approach in constructing benchmarks. An obvious race occurs between the index provider trying to develop a good benchmark and the investment manager trying to perform a good credit analysis to outperform an index that is heavily sovereign biased. That race is going to continue, but
©2000, Association for Investment Management and Research
I expect to see additional nongovernment bonds in global bond indexes. Rappoport: A distinction must be made between the benchmark and the index. The benchmark and the index are like a menu provided by two different sides of the market. The indexes are what the issuers want to offer. The market does have a demand side, but its composition is mainly driven by issuers (the supply side). The benchmark should reflect immunization of the investor’s liabilities. For example, it makes sense for U.S. insurance companies to invest in U.S.-dollardenominated securities because they are going to be paying out U.S.-dollar-denominated cash flows. If they choose to take active positions against an immunized U.S. dollar portfolio because they think they can add marginal return, that is another decision. Some analysts argue that U.S. investors are squeamish about being 55 percent in nondomestic bonds, even though that percentage would truly represent global market capitalization. Investors are right to be squeamish about investing that much abroad, because the liability profile of the stream of returns from foreign bonds will not look anything like the liability profile of a U.S.-based stream of returns. Dynkin: I agree with the idea that indexes are conceptually different from benchmarks. In addition to the global family of indexes, Lehman Brothers publishes about 350 customized benchmarks that reflect either the constraints or the liability profiles specific to investor clients.
57
Global Bond Management II I would also caution against any attempt to optimize index compositions in any fashion. The large presence of spread products in indexes might have been beneficial from a historical perspective or from the perspective of a particular portfolio manager. But indexes should be constructed to have “no view”; they should not be results of mean–variance or any kind of analysis in optimal combinations of market segments. Instead, they should define the opportunity set. Benchmarks, in contrast, can actually reflect investment policy objectives in the particular case of each investor, and if you view a benchmark as a “default” investment policy—that is, if a portfolio manager is not involved—the portfolio will invest itself like the benchmark. Therefore, the benchmarks do indeed need to be optimized, and they have to reflect the proper weight of spread products. Question: Have investors begun to reinvest in emerging market bonds? Williams: None of my current clients are invested in a separate emerging market bond mandate. Investors will need a lot of education, therefore, before they will adopt the Global Aggregate Index. The investment policy statement and the manager guidelines combine to make investing in emerging markets a difficult problem. It is not insurmountable, however, and we are paid to educate. So, more
58
money is likely to move overseas and into emerging markets in the future. Question: How much access do you provide to the pricing of the securities within your new indexes? Dynkin: At Lehman Brothers, aggregated index results— including reasonable subcomponents, such as sector, credit rating, and maturity range—are made broadly available to the investment community. But we share individual bond-level composition and individual prices of index securities only with clients of Lehman, and these arrangements are made on a case-by-case basis. Rappoport: J.P. Morgan makes available index returns, composition, and various other statistics for all of our indexes on a daily basis through our Web site. This information, however, is typically available to clients only. We have general EMBI+ data on our public Web site. Question: What impact will the more diversified indexes have on manager mandates? Williams: From a client perspective, certain issues arise when considering whether to adopt the U.S.-Dollar-Denominated Universal Index versus the Global Aggregate Index. Essentially, only minor marginal diversification is being
added by the Global Aggregate to the U.S. Universal, but if the client does adopt the Universal, then the client has to make a decision about whether to hire another manager or to extend the mandates of the existing bond managers. Few fixed-income managers are capable of managing emerging market bonds in an extended mandate. If you hire an additional manager, you are making a long-term strategic commitment to the asset classes. You must decide whether you want to make that long-term commitment. Given that the addition of emerging markets represents only a modest weight in the portfolio, however, one could argue that the decision affects only a modest commitment. Emerging market equities might be more appropriate than emerging market bonds as a tactical commitment. If you can move out of the commitment before the markets collapse, you can save yourself thousands of basis points. But if you have a strategic commitment, meaning a long-term commitment, and you put 5 percent of your money into emerging markets, you have locked yourself into a potentially volatile asset class that might not provide returns in excess of the Global Aggregate in the long run. Choosing whether you want to make a strategic or tactical commitment to these additional diversifying asset classes is an important decision.
©2000, Association for Investment Management and Research
Emerging Market Bond Benchmarks Peter Rappoport Head of Portfolio Research J.P. Morgan & Company, Inc.
Two expansions of the Emerging Markets Bond Index Plus are available—one that includes more securities of more countries but keeps the index capitalization weighted for the sake of liquidity, one that smoothes the weights of the countries by limiting the face amount of the debt of the larger countries. The purpose of both is to increase country and regional diversification. Investors need to understand the advantages and disadvantages of each index before choosing an emerging market benchmark.
n recent years, investors have added exposure to emerging markets in global fixed-income portfolios as a way to improve diversification and return. As a result, the need arose for emerging market benchmarks. J.P. Morgan’s contribution was the EMBI+ (the Emerging Markets Bond Index Plus). During the early- and mid-1990s, this benchmark was widely accepted by investors as a good proxy for emerging debt markets. Investor perception changed dramatically, however, after the 1998 crises in Russia and Brazil, which quickly tainted the debt of other emerging market countries. As a result of the crises, money left the emerging market asset class in droves. And when emerging market managers recovered and began to seek new management mandates, investors were highly skeptical because of the lack of country and regional diversification in the standard emerging market indexes, including the EMBI+. In years prior to 1998, investors had accepted the lack of diversification in the indexes mainly because emerging market instruments were earning superior returns. After 1998, investors viewed this lack of diversification as troubling. As a result of the changed investor perceptions, J.P. Morgan solicited the feedback of a group of investment managers about how the index could be improved. This interactive process led J.P. Morgan to introduce two additions to its family of emerging market bond indexes, the Emerging Markets Bond Index Global (EMBI Global) and the Emerging Markets Bond Index Global Constrained (EMBI Global Constrained). After a brief description of the EMBI+,
I
Editor’s note: The joint Question and Answer Session of Lev Dynkin, Peter Rappoport, and T. Jon Williams follows this presentation.
this presentation explains the composition of the two new indexes and their advantages and disadvantages.
The EMBI+ Since 1992, the standard index in emerging markets has been the EMBI+. J.P. Morgan’s first emerging market bond index was the EMBI and included only Brady bonds. When the index was expanded to include more than Brady paper, the name was changed to EMBI+. As of October 1999, the index’s market capitalization was about USD140 million and was composed of 76 bonds from 16 countries. Major Advantage: Liquidity. The definitive characteristic of the EMBI+ is liquidity. Bonds must satisfy severe liquidity criteria to be admitted. Entrance hinges on the size of a bond’s bid–offer spread and the number of dealers actively quoting the bond. Table 1 presents more information on the EMBI+ criteria. To be admitted to the EMBI+, a bond’s liquidity must qualify it as L3 or better for three to six consecutive months. Bonds are removed from the index if their liquidity falls to L4 for six consecutive months or L5 for one month. The EMBI+ has a heavier representation of bonds with narrow bid–offer spreads. Figure 1 offers a comparison of the distributions of bid–offer spreads of the EMBI+ and of about 200 relatively liquid high-yield bonds regularly priced by J.P. Morgan. About 30 percent of the capitalization of the EMBI+ has a bid–offer spread narrower than 50 basis points of price (USD0.50 on a face of USD100), whereas only 6 percent of the high-yield bonds fall
©2000, Reprinted with permission of J.P. Morgan Securities Inc.
51
Global Bond Management II Table 1. J.P. Morgan’s EMBI+ Criteria A. Liquidity ranking Face Amount
Average Bid–Ask Spreadb
Brokers Providing Quotes
USD2 billion USD1 billion USD500 million USD500 million USD500 million
< 0.375 < 0.750 < 1.500 < 3.000 > 3.000
100% 50% 25% 1 broker 0 brokers
Levela L1 L2 L3 L4 L5 B. Maturity For new entries: For current entries:
Greater than 2.5 years Greater than 1 year
C. Credit rating ceiling Standard & Poor’s: Moody’s Investors Service:
BBB+ Baa1
a Only bonds b
rated L4 or higher are admitted. Based on price of USD100.
below this threshold. Panel B shows that most of the high-yield bid–offer spreads lie between 50 and 100 bps. High-yield illiquidity is reflected not only by these wider bid–offer spreads but also by the minimum transaction size that causes market prices to move. For high-yield bonds with a bid–offer spread below 50 bps, a non-market-disturbing trade ranges from USD3 million to USD5 million. As spreads widen, the amount for a non-market-moving trade decreases to USD1 million to USD3 million. These amounts can be compared with a USD20 million to USD30 million non-market-disturbing transaction in the most liquid securities in the EMBI+. Thus, benchmarking the EMBI+ is a highly liquid way of obtaining access to emerging market debt. Investors benchmarked to the EMBI+ can move easily in and out of the emerging markets, which in some ways has hampered the index. The EMBI+ is a volatile index precisely because it is a vehicle for active management. The high-yield index is not a vehicle for active management because investors are punished by transaction costs when they move in and out of the securities in the index. Active traders in the high-yield index can give up in bid–offer spread what they earn over the holding period. Ultimately, liquidity in terms of both transaction size and bid–offer spread is the EMBI+’s strength. Major Disadvantage: Narrowness. The main disadvantage of the EMBI+ is the lack of diversification in the securities that make up the index, which were chosen based on strict liquidity constraints. More than 80 percent of the index is in Latin American securities—27 percent in Argentina, 23 percent in Brazil, 18 percent in Mexico, and 6 percent in Vene-
52
zuela. This heavy concentration in Latin American debt is what generated investors’ recent concerns about the lack of diversity in the EMBI+. Figure 1. Bid–Offer Spreads A. EMBI+ Percent of Index 50
25
0 <50
<100
<200
<300
<400
≥400
<400
≥400
Spread (bps)
B. High-Yield Index Percent of Issuers 75
50
25
0 <50
<100
<200
<300
Spread (bps)
©2000, Reprinted with permission of J.P. Morgan Securities Inc.
Emerging Market Bond Benchmarks
Resolving the Lack of Diversity With the aid of several fund managers, J.P. Morgan began a search for ways to improve the diversification of the EMBI+ without destroying the rigors of liquidity and accessibility always perceived as valuable by users of the index. The fund management community’s suggestions for broadening the index included adding emerging market corporate issues, adding emerging market countries, and simply changing the weights of the countries in the index. The problem with adding corporate bonds of emerging market countries into the EMBI+ was that these securities tend to fall at the illiquid end of the high-yield corporate spectrum. Moreover, of those that could pass entrance requirements based on liquidity, two-thirds were Latin American corporates. So, the problem of the Latin American concentration in emerging market exposure would not have been resolved by adding corporates. Investors would not have improved their country or regional diversification at all. To avoid the lack of diversification in the index without throwing out the liquidity advantage, we took two approaches: adding countries to create the EMBI Global and changing weights to create the EMBI Global Constrained.
EMBI Global The idea of adding countries raised philosophical questions about what constitutes an emerging market. We decided to consider including the countries that satisfied the World Bank’s criteria for being of low or middle income for a period of years or that had restructured their debt over the past 10 years. The resulting classification was independent of whether the country had ever issued debt. Following the World Bank’s criteria produced about 150 countries that were possible entrants to the index. We then devised criteria for the fixed-income instrument that would govern whether the instruments the candidate countries had issued, if any, were eligible to be included in the index. We ran into several problems in analyzing the candidate instruments. For example, several instruments had cash flows that were not measurable until after they had been paid. The criteria for including instruments that we finally devised had the following requirements: The security has to • be a sovereign or quasi-sovereign, • be U.S. dollar denominated, • have a minimum original-issue face amount of USD500 million, • have at least 2 1/2 years remaining to maturity, • provide for international settlement,
• •
have measurable cash flows, and have daily quoted prices. After imposition of these criteria, 128 securities representing 27 countries survived. Our conclusion was that although 150 developing countries might fit into an emerging market index, only 27 of the countries would help diversify investors while retaining some degree of liquidity and accountability in terms of security selection. In short, the prudent investor seeking liquidity and adequate diversification may not have as large a choice in emerging market securities as at first might appear. The EMBI Global is the index that resulted from adding the countries and instruments that conformed to the criteria. We took the market-cap-based EMBI+ and added 11 extra countries and 50 extra instruments to it. The EMBI Global provides more representation in Europe and Africa and less in Latin America. The Global index improves on the EMBI+ by lowering the concentration in Latin American securities to 67 percent from 81 percent. The largest country weighting (Argentina) falls to 21 percent from 27 percent. The EMBI Global is the broadest capitalization-based benchmark that is sensible and consistent with being able to price the index on a regular basis.
EMBI Global Constrained To create an even broader index, we needed to change the weighting methodology of the 27 countries in the EMBI Global. The usual approach to changing the weights in an index is to put capitalization limits on each country in the index. For example, the countries could be divided into two groups—a 10 percent cap group and a 5 percent cap group. Fund managers told us, however, that country caps were out of the question because they create a rebalancing problem. The normal premise is that an investor buys the bonds in an index and never has to rebalance, but an index with cap limits raises the possibility that the investor will have to rebalance to stay neutral. If, for example, a country is at its limit—set at a 10 percent weight— but appreciates in value relatively more than the rest of the countries in the index, investors will have to sell off the excess to get back to neutral. Requiring rebalancing is not an attractive characteristic of a benchmark. So, with the second index we introduced, the EMBI Global Constrained, we attempted to smooth out the weights across the different countries without requiring rebalancing. Rather than limit the market capitalization of each bond or each country, the Constrained index limits the face amount of the debt of larger countries in the index, thus lowering the presence of the big countries and raising the presence of the small ones.
©2000, Reprinted with permission of J.P. Morgan Securities Inc.
53
Global Bond Management II Every dollar of face amount for the bonds in the index is included in the EMBI Global, but only a certain proportion of the face amount is included in the EMBI Global Constrained. For example, Argentina, which has USD42 billion in face value of outstanding debt, has only USD14.75 billion of face value in the Constrained index because the index accepts successively smaller amounts of each marginal dollar of face value of debt issuance. The “tax” on each marginal dollar of issuance grows larger as country issuance increases. That is, larger countries with higher capitalizations are penalized more than those with lower capitalizations.
Comparing the Indexes The weights in the EMBI Global Constrained bring this EMBI index much more into line with our diversification goals than the changes introduced in the EMBI Global. Table 2 compares the regional weights for the three EMBI versions. Overall, the country weights are in the ballpark of ERISA diversification guidelines. There is a significant reduction in Latin American representation in the EMBI Global Constrained when compared with the EMBI+. Table 3 compares the weights of the major Latin American countries in the three indexes. The largest Latin Amer-
Table 2. Weights of Emerging Market Regions, October 1999 Region
EMBI+
EMBI Global
EMBI Global Constrained
Latin America
81%
67%
53%
Europe
13
14
17
Asia
4
15
22
Africa
2
4
7
—
1
1
Middle East
Note: Percentages may not sum to 100 because of rounding.
Table 3. Latin American Country Weights, October 1999 Country
EMBI+
EMBI Global
EMBI Global Constrained
Argentina
27%
21%
12%
Brazil
23
20
11
Colombia
1
1
2
Ecuador
1
1
2
Mexico
18
15
12
Panama
2
2
3
Peru
2
1
2
Venezuela
6
6
8
54
ican country weight in the Constrained index is only 12 percent (Argentina), compared with the largest Latin American weight in the Global index of 21 percent (Argentina). The next question is: How have these new indexes performed? A comparison of return performance shows little difference in returns between the old EMBI+ and the two new indexes. Volatility of returns, however, falls successively from the EMBI+ to the EMBI Global to the EMBI Global Constrained. Monthly performance, as graphed in Figure 2, clearly shows little difference between the EMBI+ and the EMBI Global Constrained. The Constrained index smoothes volatility but not enough to justify a shift from one index to another. The primary source of short-term volatility is flight to quality, which tends to affect all emerging markets similarly. The advantage of these new indexes, therefore, is not in improved performance or reduced short-term volatility, and new money has not flooded into emerging markets away from other asset classes with the emergence of these new indexes. The real advantage in switching to one of the new indexes with broader diversification is a decrease in the investor’s long-term exposure to risk—that is, exposure to defaults. Default occurrence is considered to be idiosyncratic; if countries’ economic bases differ, default experience is expected to be unrelated. Thus, default events and the timing of those events should differ among emerging market countries. The result is less uncertainty and less long-term volatility in indexes with wide country diversification, such as the EMBI Global and the EMBI Global Constrained. Imagine a meltdown in emerging markets far surpassing the crises of 1998 and accompanied by a large country default. Investors in that country’s bonds recover nothing. If that country makes up 20 percent of the EMBI+, then in terms of market value, the EMBI+ loses 20 percent (assuming that no other country is affected). The same country’s weight in the EMBI Global is 12 percent, so investors with an EMBI Global mandate lose only 12 percent. So far, those invested in the EMBI Global are ahead of the game by 8 percentage points. But is this scenario totally accurate? The expectation that default among countries is unrelated may be false. Because of the regionalization of emerging markets, a spillover effect from one defaulting nation to other nations in the same region could occur. Typically, when a large emerging market country gets into trouble, the sky falls in: Global capital markets shut down, and many developing countries, particularly the smaller countries, have difficulty retaining access to capital markets. If a large emerging market country defaults, so many small
©2000, Reprinted with permission of J.P. Morgan Securities Inc.
Emerging Market Bond Benchmarks Figure 2. EMBI+ versus EMBI Global Constrained: Monthly Returns, January 1994–September 1999 Return (%) 15 10 5 0 –5 –10 –15 –20 –25 –30 –35 1/94
1/96
1/95
1/97
EMBI+
1/98
1/99
9/99
EMBI Global Constrained
countries can get into trouble that an investor could lose more by being in the EMBI Global than by being in the EMBI+. Only in this situation would the diversification of the broader indexes be a bad idea. An investor might have better protection in such an event by investing in only the large developing countries. Large countries generally have greater ability to tap their domestic capital markets, and international financing authorities are also more likely to deem them too big to fail. Therefore, these countries have a greater chance of a bailout. Small countries do not have large domestic capital markets
and may be thought too small for a bailout. In this case, an investor would be better off in an index dominated by the large emerging markets. How likely is the possibility that an investor might be worse off by being invested in the smaller, weaker countries when a big default occurs? Figure 3 provides clues as to how long the shutdown of global capital markets following big defaults can be expected to last. It charts new issuance by emerging market sovereigns in all currencies from 1992 through June 1999, shortly after the Russian crisis developed. Major dips in financing did indeed occur at the time of each
Figure 3. Length of Nuclear Winter in the Global Bond Markets, January 1992–June 1999 Issuance (USD billions) 5,000 4,000 3,000 2,000 1,000 0 1/92
1/93
1/94
1/95
Mexico, Brazil, and Argentina
1/96
1/97
1/98
1/99
Other Emerging Markets
Note: Shaded lines represent emerging market crises in, respectively, Mexico (1995), South Korea (1997), and Russia (1998).
©2000, Reprinted with permission of J.P. Morgan Securities Inc.
55
Global Bond Management II of the major emerging market crises—Mexican, Korean, and Russian. In each instance, however, a rebound in financing availability took only several months. The shutdown period lasted from four to six months. Given the crises that we have seen so far, four to six months has not been enough time for any small country to get into trouble as a result of not being able to finance. Therefore, the possibility that an investor might be worse off by being invested in the smaller countries when default of a large country occurs appears to be slim. Global capital markets reopen quickly enough to support the advantages of broad country diversification.
Conclusion An important difference exists between having either of the EMBI global indexes as a benchmark and having the EMBI+ as a benchmark. Getting invested in the global indexes is more of a challenge. Especially challenging is the Constrained index because it is not a market-cap index: The small countries do not have enough paper to allow each investor to reach the index weighting. As a result, managing funds with the Constrained index as the benchmark is not a passive pursuit. Becoming neutral to the index
56
requires actions that are tantamount to active management; it requires the manager to acquire bonds that not all investors can acquire. Managers should make sure investors understand this unique dimension of the new indexes if they expect their investors to be satisfied with the strategy in the long term. Investors in the new global indexes should not expect a new era of low volatility to dawn. In the short term, the global indexes will be as volatile as the EMBI+ because much of the EMBI+’s liquidity has been preserved in the new indexes. Over the long term, however, the investor in a global index will significantly diversify default risk in emerging markets, which was the goal behind the design of the new indexes. A final word about the new indexes: The EMBI Global and EMBI Global Constrained have found acceptance among investors. Most of our clients are moving their emerging market mandates to either the Global or the Global Constrained. The index preference differs, however, between fund managers in the United States and those in Europe. About two-thirds of U.S. managers have opted for the Global, whereas about two-thirds of European managers have opted for the Global Constrained.
©2000, Reprinted with permission of J.P. Morgan Securities Inc.
Global and Emerging Market Bond Benchmarks
Question and Answer Session Lev Dynkin Peter Rappoport T. Jon Williams, CFA1 Question: How can one deal with the lack of history for a portion of the Global Aggregate Index when assessing risk exposures and performing optimizations? Dynkin: Generally, when Lehman Brothers launches a new index, we try to complete the history as far back as prices permit. In the case of the Pan-European Index, especially its EMU component, that practice was not very useful because the history of the European corporates prior to EMU has little to do with their history post-EMU. This problem explains why we used only history from December 1998 to the present in calculating the standard deviation for the Global Aggregate Index. The lack of historical data is also a problem in developing risk models that use historical variances and correlations of factors in those markets. Some creative ways of dealing with this problem, however, have been developed. Many portfolio managers in Europe, for example, think that the euro corporates’ historical behavior can be imputed from the history of U.S. corporates, although the idea is debatable. How to fill in legitimate historical gaps—not ones for which we don’t have an index but gaps of time in which no market existed—is an issue that needs to be addressed on a case-by-case basis. 1T. Jon Williams, currently a director at InvestorForce.com (formerly Asset Strategy Consulting), joined Mr. Dynkin and Mr. Rappoport for this Question and Answer Session.
Question: Could you expand on what is wrong with an equally weighted index, such as an equal weight by country capitalization? Rappoport: There are simply not enough bonds issued and available in the market for investors to benchmark the full weighting if equal weights are used. For some of the smaller countries, the gap between capitalization (the amount of outstanding bond issuance) and the weight in such an index would be huge. The Ivory Coast, for example, is 0.1 percent in terms of capitalization. We have 27 countries, and under equal weighting, each weight would be about 3.5 percent. Then, somehow, portfolio managers would have to get 3.4 percent more in securities for the Ivory Coast than the country’s market cap. Such a trick would certainly be good for the price of Ivory Coast bonds, but it would not have any other merits. Question: Recent studies, some by J.P. Morgan & Company, argue that global portfolios should be invested against non-capweighted benchmarks and also have large (60–80 percent) nongovernment exposure. Will index providers or consultants be pushing these concepts? Williams: You need a capitalization approach in constructing benchmarks. An obvious race occurs between the index provider trying to develop a good benchmark and the investment manager trying to perform a good credit analysis to outperform an index that is heavily sovereign biased. That race is going to continue, but
©2000, Association for Investment Management and Research
I expect to see additional nongovernment bonds in global bond indexes. Rappoport: A distinction must be made between the benchmark and the index. The benchmark and the index are like a menu provided by two different sides of the market. The indexes are what the issuers want to offer. The market does have a demand side, but its composition is mainly driven by issuers (the supply side). The benchmark should reflect immunization of the investor’s liabilities. For example, it makes sense for U.S. insurance companies to invest in U.S.-dollardenominated securities because they are going to be paying out U.S.-dollar-denominated cash flows. If they choose to take active positions against an immunized U.S. dollar portfolio because they think they can add marginal return, that is another decision. Some analysts argue that U.S. investors are squeamish about being 55 percent in nondomestic bonds, even though that percentage would truly represent global market capitalization. Investors are right to be squeamish about investing that much abroad, because the liability profile of the stream of returns from foreign bonds will not look anything like the liability profile of a U.S.-based stream of returns. Dynkin: I agree with the idea that indexes are conceptually different from benchmarks. In addition to the global family of indexes, Lehman Brothers publishes about 350 customized benchmarks that reflect either the constraints or the liability profiles specific to investor clients.
57
Global Bond Management II I would also caution against any attempt to optimize index compositions in any fashion. The large presence of spread products in indexes might have been beneficial from a historical perspective or from the perspective of a particular portfolio manager. But indexes should be constructed to have “no view”; they should not be results of mean–variance or any kind of analysis in optimal combinations of market segments. Instead, they should define the opportunity set. Benchmarks, in contrast, can actually reflect investment policy objectives in the particular case of each investor, and if you view a benchmark as a “default” investment policy—that is, if a portfolio manager is not involved—the portfolio will invest itself like the benchmark. Therefore, the benchmarks do indeed need to be optimized, and they have to reflect the proper weight of spread products. Question: Have investors begun to reinvest in emerging market bonds? Williams: None of my current clients are invested in a separate emerging market bond mandate. Investors will need a lot of education, therefore, before they will adopt the Global Aggregate Index. The investment policy statement and the manager guidelines combine to make investing in emerging markets a difficult problem. It is not insurmountable, however, and we are paid to educate. So, more
58
money is likely to move overseas and into emerging markets in the future. Question: How much access do you provide to the pricing of the securities within your new indexes? Dynkin: At Lehman Brothers, aggregated index results— including reasonable subcomponents, such as sector, credit rating, and maturity range—are made broadly available to the investment community. But we share individual bond-level composition and individual prices of index securities only with clients of Lehman, and these arrangements are made on a case-by-case basis. Rappoport: J.P. Morgan makes available index returns, composition, and various other statistics for all of our indexes on a daily basis through our Web site. This information, however, is typically available to clients only. We have general EMBI+ data on our public Web site. Question: What impact will the more diversified indexes have on manager mandates? Williams: From a client perspective, certain issues arise when considering whether to adopt the U.S.-Dollar-Denominated Universal Index versus the Global Aggregate Index. Essentially, only minor marginal diversification is being
added by the Global Aggregate to the U.S. Universal, but if the client does adopt the Universal, then the client has to make a decision about whether to hire another manager or to extend the mandates of the existing bond managers. Few fixed-income managers are capable of managing emerging market bonds in an extended mandate. If you hire an additional manager, you are making a long-term strategic commitment to the asset classes. You must decide whether you want to make that long-term commitment. Given that the addition of emerging markets represents only a modest weight in the portfolio, however, one could argue that the decision affects only a modest commitment. Emerging market equities might be more appropriate than emerging market bonds as a tactical commitment. If you can move out of the commitment before the markets collapse, you can save yourself thousands of basis points. But if you have a strategic commitment, meaning a long-term commitment, and you put 5 percent of your money into emerging markets, you have locked yourself into a potentially volatile asset class that might not provide returns in excess of the Global Aggregate in the long run. Choosing whether you want to make a strategic or tactical commitment to these additional diversifying asset classes is an important decision.
©2000, Association for Investment Management and Research
