In our last piece we reviewed a few major concerns and attributes with regard to the US fixed income market. The major issues included inflation uncertainty, stretched valuations and overall low real yields.

We will now examine the global debt market landscape to aid advisors and investment committees in their quest to provide reasonable fixed income solutions in an environment that seems very unreasonable.

We begin our international journey by taking a look at the Treasury Bond Index outside of the US.

I-Shares International Treasury Bond ETF (IGOV)
S&P/Citigroup International Treasury Bond Index Ex-US ($)

This ETF holds a yield of .82% yield and a duration of 7.22 and this is to be expected with a 22% weight to Japan. Obviously, this fund tracks an index that possesses an antiquated market weight scheme.

This high duration has helped fuel the 7.65% plus rally in the last year in an otherwise anemic index that has not displayed signs of credit improvement overall. The deflation fears in Europe have helped drive this massive performance as the fundamental picture has not improved enough to warrant this significant performance. There has been and to some degree a hope that this deflationary fear will lead to massive liquidity on the part of the ECB, driving yields to even lower levels.

Some of the least fundamentally strong countries such as Greece have performed the best as this liquidity induced risk on trade has taken the lower credits and driven them in our estimation to long term unsustainable price levels.

According to Lazard, “The outlook on European fixed income is uncertain due to the diverging policy paths of the US Federal Reserve (the Fed) and the ECB. In the
United States, the Fed will most likely continue tapering its bond purchases and the rumors of a rate-hike in 2015 have not subsided. However, the ECB will continue its easy money policy for the foreseeable future.”

“The recovery in Europe remains uneven as the region gradually exits a recession. The European banking system is still in trouble and there has been no progress in the banking union discussion. Uncertainty exists for a number of reasons, including the ECB’s upcoming banking stress tests and the Russian/Ukrainian crisis, which could further dampen sentiment in the European economy. Against this backdrop, it is no surprise that the disinflationary trends in the European economy have accelerated in the last months to the point that there are concerns about deflation.”

“Regardless of how the Fed acts regarding US monetary policy, it is clear that the ECB wants to keep the short end of the yield curve well anchored. But, it is uncertain what
the combination of a tighter Fed policy and an even more accommodative ECB policy means for the European fixed-income market and the euro.”

Zenith feels that this uncertainty and the real possibility of divergent gains moving forward in European Sovereign debt markets, warrants an active manager as opposed to a passive ETF that lacks the nimbleness needed to navigate these areas.

Lazard “expects European core government bonds to continue to trade in the relatively tight range established in the last quarters with the biggest risk a bond bear market in the US.”

Looking forward, “Lazard expects sentiment about spread products to remain positive in third quarter of 2014. The majority of lower-rated spread products are still more attractively valued compared to the extremely low-yielding money market products, core European government bonds, and highly rated covered and corporate bonds. However, we expect the market to become tougher on these relatively low spread levels. We expect the strategic shift from core European bonds into the European periphery and various lower-rated spread products to continue to be a major investment theme. This shift may be enough to earn the carry of the spread products and allow for moderate tightening. In general, we remain overweight to lower-rated, high-beta spread products. However, due to the risk posed by US monetary policy, we plan to remain short in duration, but stay flexible to change course quickly, if necessary, as sentiment can abruptly sour. Recently, there have been signals of over-optimism in the global fixed-income markets, as seen by the deterioration of bond covenants, the printing of ultra-long (100-year maturity) bonds, and the oversubscription of almost all new issues. In addition, despite the return of geopolitical risk in the last quarter, due to the events in Ukraine, Iraq, and Syria, all global risk indicators have fallen to very low levels. Because of this over-optimism, we expect some volatility in the months ahead, at least until the focus on risks returns. As active asset managers, we plan to take advantage of the anticipated turbulence to make tactical asset allocation and market-timing decisions.

In its 2014 Outlook for Financial Markets, Swiss Life Asset Management states, “The meeting of central bankers in Jackson Hole has confirmed our previous view of diverging monetary policies. Hence, we expect the Bank of England and Fed to start hiking in 2015 and the ECB and Bank of Japan to stay accommodative.”

This appears to us to be a bond world that is not necessarily going to be rising in unison as we move forward in 2014 and into 2015. Once again we would like to emphasize the importance in this uncertain policy world to have a manager that is able to analyze the macro landscape as well as the micro credit work.

While the healthy returns could continue, we believe it will take a nimble and adept manager to be able to sort through the risks and potential rewards.

I-Shares USG Emerging Markets (EMB)
J.P. Morgan EMBI Global Core Index

This ETF holds a 4.25% yield and a duration of 7 which has helped it gain over 13% over the last year. The dollar denomination also helped as did a rebound in most Emerging Market risk assets.

I-Shares Emerging Market Local Currency ETF (LEMB)
J.P. Morgan EMBI Global Core Index

This ETF holds a 4.91% yield and a duration of 4.25 and this after a nice 10% plus return over the last year.

Given two ETFs with the exact opposite currency mandate, it becomes difficult to choose unless an investor has the time and infrastructure. to be able to make currency calls. We believe it is more prudent to seek an active manager who can chose the best securities in both worlds.

The outlook for the emerging world is likely to be mixed as there are many countries with varied policies that will affect real rates, inflation expectations as well as credit conditions.

Research Affiliates Shane Shepard delves into the Emerging Market bond space to explain the areas that they find opportunities within fixed income in their latest piece dated July 2014.

“Emerging market sovereign bonds that are issued in local currencies are supported by high real yields and improving credit quality. In addition, their risk-to-reward profile is enhanced by declining currency volatility and a positive long-term outlook for currency appreciation.”

• High real yields-The short- and medium-term “risk-free” government bond rates for the G-5 countries all currently reside in negative territory (see Figure 1). In developed markets, the right to a certain return of capital is actually costing anywhere from –1.5% to –0.5% per year in real purchasing power. On the other hand, real yields in many of the larger emerging market economies reside solidly in positive territory—returning anywhere from about a 1% premium over inflation in Mexico and Russia to more than 6% in the case of Brazil.

• The historical spread for the J.P. Morgan GBI-EM Global Index is just under 7% as the difference between the index yield and the short-term U.S. Treasury rate lies well above its long-term average of 5.2%. But, most strikingly, this spread has rebounded (due to the well-documented “taper tantrum” of 2013) to levels just a touch below its all-time high during the 2008 global financial crisis!

• Currency Appreciation-The volatility of local currencies is undeniably substantial; the currency risk swamps the volatility of the underlying bonds. Nonetheless, the currency exposures may provide an incremental boost to long-run expected return. Because of the differences in productivity growth, in the long run we expect emerging market currencies to appreciate relative to the U.S. dollar and other major developed world currencies.

• Currency volatility-At least for the past five years, a basket of emerging market currencies has contributed no more volatility to an international portfolio than a basket of developed currencies. And as emerging markets continue to do just that—emerge—the convergence of currency risks may be expected to continue.

• Credit quality-The fourth factor is the strengthening credit quality of emerging market bonds. 15 years ago only a handful of countries were in a position to issue local currency debt, and their average credit rating was BBB+. Now many more countries participate in the local currency debt market, and the average credit rating is closer to A–.

There is an interesting dynamic at play in the emerging market debt arena especially after the rate hikes by many of the countries attempting to bolster their currency. The rate hikes have, depending on the basket allowed for a 500 basis point advantage over US Treasuries.

According to Lazard, “Local emerging markets debt has been the bogeyman of the broad asset class for the past three-and-a-half years. Over this period, the local currency index, including spot currency rate changes, carry, and bond moves, has underperformed the dollar-denominated debt index by a whopping 19.1% on a cumulative basis and 4.80% on an annualized basis. The drivers of local market debt’s underperformance have been myriad; however, the key negative factors have been (a) an overvalued starting
point, (b) deteriorating fundamentals that affect local debt, (c) less correlation and duration of local debt to falling US Treasury yields, and (d) a moribund global economy. It is our view that all four factors that have pressured emerging local market returns over the last several years are in the process of turning, and will likely result in local market debt outperforming every part of the emerging markets debt asset class in the second half of 2014 and into 2015. We elaborate on these four factors here: First, emerging markets debt has had one of the greatest bull runs of any asset class from 2003 to 2010. Even including the early years of the financial crisis, external debt returned 10.6% on an annualized basis, while local debt returned 13.6%. Notably, the spot currency portion of local currency debt returned just 2.7%, annualized, over this period, while the carry and yield compression returned over 10%, annualized. By the end of 2010, most emerging markets currency valuations were trading richly to their historic real exchange rate averages, while the real yield differential between emerging markets and the United States had compressed to approximately 2%.

Strategically they are looking for the US Ten Year Treasury to return to its 3% Jan trading level and “this ought to weigh on assets with high correlations to Treasuries, such as global investment-grade and emerging markets hard currency bonds, and favor shorter-duration, more idiosyncratic markets, such as emerging markets local debt.
In summary, while we maintain our defensive stance across emerging markets due to stretched valuations, we certainly plan to add local debt in the second
half of the year to all our multi-asset class portfolios. The key triggers to make that asset allocation decision are an improving US economy that leads to a
deteriorating US current account balance and more attractive entry points following what we expect to be a weak summer for fixed income asset”

This is a very difficult time for investment firms that have to allocate a certain percentage to fixed income and bonds in general. Here is a brief summary with regard to the challenges ahead that will lay the groundwork for our next piece that will have potential solutions.

• US valuations on most debt classes are stretched and spreads are tight by most measures and historical norms.
• European sovereign debt has performed tremendously in spite of weak fundamentals and leaves investors with a diminishing opportunity set.
• Emerging market debt offers real yields higher than their comparable developed market counterparts but also introduce currency risk and uncertainty.
• Central bank uncertainty and direction are causing potentially disastrous imbalances in the rate and currency markets.

In our next piece we will highlight a couple managers who have managed to navigate their area of the debt markets successfully and who have a reasonable mandate to be able to do so in the future.


Tom Koehler-CIO