Yields on investment-grade domestic bonds have been nonexistent for a while. Bondholders have been profiting only because already low interest rates have been pushed even lower through government policy and investors scrambling for safe havens, which have sent prices higher.
Venerable fixed-income manager Bill Gross, who runs the largest bond fund at Pacific Investment Management Co., now believes renewal of asset purchases by the Federal Reserve, a.k.a. quantitative easing, will likely signify the end of this rally. With real rates essentially negative, there isn't much more room for them to fall anyway.
This suggests advisors should be looking beyond our shores for fixed-income opportunities. The reasons: higher interest rates, improving foreign credits, compressing spreads over U.S. Treasuries and rising prices, and the renewed downward trend of the U.S. dollar are all boosting total returns from foreign bonds.
Index performance shows the benefits of international diversification. The Barclays Aggregate Bond Fund Index, which tracks U.S. investment-grade bonds, rose 7.84% over the past year through September and 5.99% annually over the last five years. Over the two same time periods, Morningstar reports the average return of World Bond funds is 8.24% and 6.59%, respectively.
Basic global bond investing strategy is based on the principle that markets tend to be at different stages in the economic cycle. For instance, when the United States is slowing down and cutting interest rates, Europe or Asia might be recovering and pushing rates up to contain potential inflation, offering greater yield. Moreover, investing in economies where rates are moving higher could further enhance returns when foreign currencies are translated back into the dollar.
But the financial crisis and subsequent collapse of interest rates across the developed markets have broken this pattern, leaving no obvious place in which global fixed-income investors should be. Accordingly, it has fed the flow of assets into emerging market bonds, which have generated the highest returns of all fixed-income markets. [See Figures 1-3.] Morningstar reports that as of the end of October, the average emerging market bond fund is up 16.01% over the last year and 8.84% annually over the last five years.
However, it wasn't that long ago when massive debt crises moved across emerging markets: first in Mexico in 1994/1995; then in Southeast Asia in 1997/1998; followed by Russia in 1998; then across the Pacific to Brazil and Argentina in 2001/2002. In excess of $100 billion was defaulted upon, forcing many investors to take sizable haircuts in restructuring.
Fundamental improvements have since occurred in emerging markets, making many safer than they were. "Foremost, these countries have realized capital markets are essential to have on one's side," explains Joseph Portera, co-portfolio manager of the $444 million Hartford Strategic Income Fund that's up more than 13% over the past year. "They better understand antagonizing foreign investors through unfavorable refinancing or currency devaluation is not in their best interests." Since the 1990s, many countries have adopted improved fiscal and monetary policies to assuage capital market concerns and enhance their own financials.
Second, most emerging currencies have been delinked from the dollar. Unsustainable local currency correlation with the dollar was a root cause of many emerging market crises. Free-floating currencies enable markets to continuously respond to external stresses, avoiding a buildup of economic imbalances that in the past required a major shock to relieve pressure.
Third, emerging markets are now less exposed to excessive budgetary and trade imbalances, observes Sara Zervos, co-portfolio manager of Oppenheimer's $13.8 billion International Bond Fund, which has generated ten-year annualized returns of nearly 12%. Strong demand for commodities has generated tremendous trade inflows, enhancing capital reserves. Significant foreign direct investment-acquisitions and joint ventures-has attracted more committed foreign capital.