Download Asian Investment Grade USD Bonds an Under Appreciated Asset

BMO Exchange Traded Funds
Asian Investment Grade USD Bonds
an Under Appreciated Asset Class
Since the financial crisis in 2008, both bond and equity markets have had solid performance. While the
returns in equity markets may have been more pronounced, one only has to look back to the financial
crisis to remember the true value of bonds. The importance of holding bonds in portfolios is abundantly
clear when there is a crisis and fear pervades the financial markets. As such, bonds should be an important
component of most investors’ portfolios and should not be overlooked.
While investors have a wide range of objectives and goals
The ultimate aim is to demonstrate:
that guide their investment choices, their allocation to bonds
1. Why invest in bonds?
typically serve a common purpose: to provide income and
reduce overall portfolio risk. In this paper we will focus on how
bond from Asian ex-Japan issuers can fulfill this role. As Asia
2. What is the difference between hard currency and local
currency bonds?
ex-Japan nations are predominantly emerging market (EM)
3. Why invest in Asia ex-Japan USD investment grade bonds?
nations, an appropriate comparison group for Asia ex-Japan
4. What works better in a portfolio and why?
bonds is EM bonds. Attention will be focused on investment
grade bonds which tend to be lower risk profile investments
1. Why invest in bonds?
with strong diversification benefits to portfolios.
Bond investing is all about generating income while limiting
Not all EM bonds are the same and as such have varied
risk. At the most fundamental level, bonds are simply a
characteristics. Typically they will be grouped into one of two
commitment by a borrower to repay their lenders, providing
buckets, either local currency bonds, which are issued and
a steady stream of income to investors until the principle is
trade in the local currency of the issuer (e.g. pesos, rupiah,
repaid. While the price of a bond may be influenced by market
baht etc.) or hard currency bonds, which usually means the
forces, the amount of income they produce typically is not.
bonds are denominated in United States Dollars (USD). The
Consequently, the income generated by bonds is predictable
discussion below will attempt to differentiate some of the key
even if the prices of bonds fluctuate. For many investors this
characteristics of these two types of EM bonds. It will provide
is the key reason to hold bonds. As can be seen in the table
a better understanding of how they are both unique, with
below, coupons tend to represent the bulk of returns for bond
distinctly different investment outcomes, a point that is
investors but more importantly provide a very stable stream of
often not fully appreciated by investors.
recurring income for investors.
BMO Exchange Traded Funds
Asian Investment Grade USD Bonds – an Under Appreciated Asset Class
PAGE 2
2. Local currency bond vs USD bond – is there much
difference?
US Bonds Annual Returns
In a word – YES. The pattern of returns for USD denominated
15.0%
bonds and local currency bond is dramatically different. The risks
10.0%
associated with and drivers of returns are also very different.
5.0%
1
Local currency bonds
USD denominated bonds
Primary drivers
(domestic factors)
Primary drivers
(US & global factors)
Balance of payments
Balance of payments
Local interest rates relative to
interest rates in other countries
US interest rates
Inflation rate in local economy
US inflation rates
intent to reduce overall portfolio risk. This is because bonds
Local government fiscal policy
Factors affecting US economic outlook
tend to perform well when equity markets are weak and
Issuer specific factors
Issuer specific factors
this is particularly the case with high credit quality bonds.
Credit rating of country
Credit rating of country
Lack of trading liquidity
Monetary policy in USA
but this was by no means a unique event as the chart below
Primary source of volatility
Primary source of volatility
demonstrates. By having both bonds and equities in the same
Movements in currency
US interest rate moves and changes
in credit spreads
0.0%
Jun-1987
Jun-1992
Jun-1997
Jun-2002
Jun-2012
Jun-2012
-5.0%
Annual Coupon
Annual Total Returns
Source: Barclays. Annual Returns based on Barclays US Aggregate Total Return Index. Past
performance not indicative of future results.
Bonds typically are less volatile than equities and high
credit quality bonds are often added to portfolios with the
The perfect example of this was during the financial crisis –
stocks plummeted in 2008 while US bonds rallied in value,
portfolio, the weakness in one is offset by gains in the other,
significantly reducing overall risk in the portfolio.
Bond returns vs equity returns – 10 worst down quarters for S&P500s over the past 40 yrs
10%
0.0%
2
(10.0%)
(20.0%)
(30.0%)
4Q 1987
3Q 1990
1Q 2001
3Q 2001
2Q 2002
3Q 2002
4Q 2008
1Q 2009
2Q 2010
US Bonds
5.8%
0.9%
3.0%
4.6%
3.7%
4.6%
4.6%
0.1%
3.5%
3Q 2011
3.8%
S&P 500
(22.5%)
(13.7%)
(11.8%)
(14.6%)
(13.4%)
(17.2%)
(21.9%)
(11.0%)
(11.4%)
(13.8%)
Source: Bloomberg & BMO Global Asset Management. US bond performance above represented by the Barclays US Aggregate Total Return Index. Measured from June 1976 to June 2015.
Past performance not indicative of future results.
BMO Exchange Traded Funds
Asian Investment Grade USD Bonds – an Under Appreciated Asset Class
PAGE 3
Interest rates tend to be higher in EM nations due to domestic
It is possible that stronger EM currencies could generate
economic factors. Often they are a reflection of local monetary
incremental returns for investors in local currency bonds, but
policy and higher inflation rates. The higher yields do not
over a longer time frame this has not been the pattern. The
necessarily translate into higher returns vs USD denominated
currency movements tend to move in long cycles and can
bonds, as demonstrated in the chart below. The pattern varies
move up or down for many years at a time, but over the
considerably based on the time period, but typically the currency
last 3 decades EM currencies have tended to weaken vs the
exposure tends to add incremental volatility rather than returns.
US dollar as shown in the charts below. While this pattern of
100%
36 month rolling currency returns
weakness was pronounced in the 1990’s, it was not unique
090%
50.0%
to that period. The chart on the right shows that this pattern
25.0%
080%
Asian EM Local Currency Bonds
vs USD Bonds
0.0%
has also persisted since 2000. Weakness in currencies tends
070%
-25.0%
to offset the impact of higher yields that local currency
-50.0%
060%
7/1/1996
7/1/2001
7/1/2006
EM 1
7/1/2011
bonds typically offer vs USD bonds. With this context, the
050%
8.0%
advantage of investing in local currency bonds is only clear
6.0%
040%
in environments that are likely to see stronger EM currencies
4.0%
030%
and a weaker US dollar. If investors lack conviction that
2.0%
020%
EM currencies will appreciate in value, they are likely better
0%
010%
Return
Volatility
USD bonds
6.5%
3.9%
Local currency*
5.9%
7.8%
served investing in USD EM bond.
00%
1993
1998
2003
2008
2013
Uxxx
EM Currency Composite
Source: Barclays, * Local currency bond returns are expressed in US dollar terms. Returns
measured from October 2009 to May 2015. Past performance not indicative of future results.
EM Currency Depreciation vs US Dollar – 10 Largest EM Nations
100%
EM 2
0150%
36 month rolling currency returns
36 month rolling currency returns
090%
0140%
50.0%
25.0%
080%
50.0%
25.0%
0130%
0.0%
0.0%
070%
-50.0%
060%
7/1/1996
Post Asia
Financial Crisis
Uxxx
2000 to present
0120%
-25.0%
7/1/2001
7/1/2006
7/1/2011
EM 1
0110%
050%
0100%
040%
090%
030%
080%
020%
070%
010%
060%
-25.0%
-50.0%
12/1/02
12/1/05
12/1/08
12/1/11
12/1/04
050%
00%
1993
1998
2003
2008
2013
2000
2005
2010
2015
Uxxx
EM Currency Composite
Uxxx
EM Currency Composite
Source: Bloomberg & BMO Global Asset Management. Currencies used in the equal weighted currency composite above include: Brazil, India, Russia, South Korea, Mexico, Indonesia, Turkey,
Poland, Thailand and South Africa. Past performance not indicative of future results.
0150%
36 month rolling currency returns
0140%
50.0%
EM 2
BMO Exchange Traded Funds
Asian Investment Grade USD Bonds – an Under Appreciated Asset Class
3. W
hy invest in Asia ex-Japan USD investment
grade bonds?
In short, because of the relatively high returns and the
diversification benefit they offer. On a risk adjusted basis
they tend to offer yields that are higher vs comparable bonds
from developed markets. The table below shows the returns
and volatility of the several types of bonds over the last 5
years. As can be seen in below EM bonds can offer superior
Table 1
PAGE 4
returns relative to US bonds. The EM bonds in this table are
geographically diversified across regions. Over this time
period, local currency bonds had weaker performance and
higher volatility. In contrast, EM bonds in USD term had solid
performance with returns approaching those available from
US high yield bonds (also known as ‘junk bonds’ as they invest
in low credit quality bonds). Note that the ratio on the right
shows the amount of return investors gain per unit of risk
(Sharpe Ratio), which is a way to evaluate risk adjusted returns.
Selected Equity and Bond Markets – Risk and Returns
Sharpe Ratio
1.5
0.4
1.1
1.3
<------ Return Volatility ------>
US Bond Aggregate
EM Local Currency Bonds
EM USD Bonds
US High Yield Bonds
10%
5%
0%
5%
10%
Source: Barclays and IBOX Index data. Returns and volatility measured from October 2009 to May 2015. Past performance not indicative of future results.
Table 2
Table
Below
we1focus in how bonds from the Asia region compare
without a significant increase in assumed risk (volatility). The
comparisons
While equity
<----------->vs equity markets is also instructive.Sharpe
and also shows the risk/return metrics for equities. This
clearly
Return Volatility
Ratio
<------ Return Volatility ------>
Sharpe Ratio
1.5
markets
typically
offer
potential
for
higher
returns,
the
risks
demonstrates
the
value
proposition
of
Asia
ex-Japan
bonds,
US
1.5
US Bond
Bond Aggregate
Aggregate
0.7
Asia
EM
Local
Bonds
are
proportionally
higher.
The
Sharpe
ratio
for
Asia
ex-Japan
which
is
especially
notable
for
USD
denominated
bonds.
They
0.4
EM Local Currency Bonds
1.6
Asia
ex-Japan
USD
Inv.
Grade
Bonds
USD investment grade bonds is very favorable. 1.1
EM high
USD Bonds
offer
return potential vs other types of bonds but
1.3
US
1.3
US High
High Yield
Yield Bonds
Bonds
0.3
EM Equity
10%
5%
0%
5%
10%
0.5
EAFE Equity
1.3
S&P 500
Table 2
10%
5% vs EM Bonds
0%
5% and Returns
10%
Developed
Market
– Risk
<------ Return Volatility ------>
Sharpe Ratio
1.5
0.7
1.6
1.3
0.3
0.5
1.3
US Bond Aggregate
Asia EM Local Bonds
Asia ex-Japan USD Inv. Grade Bonds
US High Yield Bonds
EM Equity
EAFE Equity
S&P 500
10%
5%
0%
5%
10%
Source: Barclays, MSCI, IBOX and S&P Index data. Returns and volatility measured from October 2009 to May 2015. Past performance not indicative of future results.
These asset classes react to changes in the market in different
ways. Some may react more adversely to rising interest
rates than others while some may react poorly to negative
developments in the markets. For bonds, these two factors are
known as interest rate risk (measured by duration) and credit
risk (represented by credit ratings), respectively.
BMO Exchange Traded Funds
Asian Investment Grade USD Bonds – an Under Appreciated Asset Class
To elaborate on this point we have made an apples-to-apples
comparison of US bonds vs Asia ex-Japan USD investment grade
bonds, explicitly adjusting for the differences in credit quality and
duration. The yields generated by these two types of bonds are
shown in the graph below. The Asian bonds have consistently
offered a superior yield. The smaller chart in the upper right
corner shows the incremental yield generated by Asia EM bonds.
Since the financial crisis, Asia ex-Japan USD investment grade
bonds have offered a yield premium (YTW) of over 50 bps per
annum relative to similar US bonds. This is a compelling reason
for any investor that invests in US bonds to evaluate the options
available in Asia ex-Japan USD investment grade bonds.
PAGE 5
4. What works better in a portfolio and why?
Returns and volatility are major drivers of the asset allocation
decisions, but there is one more key piece of information
involved – namely correlation. Correlation measures how each
type of investment moves in relation to other investments in
a portfolio and is the key attribute that defines the benefits
of diversification. It is the old “putting all your eggs in the
same basket” concept. For investments, this means holding
assets that are dissimilar, have different characteristics and
react differently to market events. Accordingly investors
should actively seek to hold investments that have low
correlations with each other. Hence, balanced portfolios will
have allocations to both bonds and equities. Bonds, especially
investment grade bonds, are often seen as safe investments
Asian Bond Yields vs US Bond Yields
that provide yield and stability to a portfolio. Equities on the
other hand, provide growth but are more risky. When investors
6.5%
Asian Bond yields US Bond Yields
Asian USD IG Bond yield pick-up
start getting worried, stocks often fall in value while bonds
2.00%
tend to hold their value or rise. This was certainly the case
1.50%
5.5%
during the peak of the financial crisis in 2008.
1.00%
0.50%
Source: Barclays and IBOX Index data. Returns
and volatility measured from October 2009 to May 2015. Past performance not indicative of future results.
0.00%
7/1/09
4.5%
7/1/10
7/1/11
7/1/12
7/1/13
7
7/1/14
In table 2 we focus in how bonds from the Asian region compare and also show the risk/return metrics for equities. This clearly
Bonds
Retain
Their
Value (often
rise)
demonstrates the value proposition of Asia ex-Japan bonds, which is especially
notable
for USD
denominated
bonds.
They offer
3.5%
Crisis
Equities
Fall
high return potential vs other types of bonds but without a significant increaseDuring
in assumed
riskWhile
(volatility).
The comparisons
vs
equity markets is also instructive. While equity markets typically
offer
potential for higher returns, the risks are proportionally
1.4
1.4
2.5%
higher. The Sharpe ratio for Asia ex-Japan USD investment1.3grade bonds
is very favorable.
1.3
1.5%
Jul 2009
Jan 2010
Jul 2010
Jan 2011
Jul 2011
Jan 2012
Jul 2012
Jan 2013
US Bond Proxy
Barclays Asia USD INV Grade Bond Index
Jul 2013
Jan 2014
Jul 2014
1.2
1.2
Jan 2015
1.1
1.1
1
1
0.9
0.9
0.8
0.8
0.7
Source: Bloomberg & BMO Global Asset Management. The US bond proxy was interpolated
0.6are
from Bloomberg data to reflect similar duration and credit quality characteristics that
reflective of the Barclays Asia USD Investment Grade Bond index. Past performance not
0.5
indicative of future results.
0.4
June-2007
8
0.7
0.6
0.5
0.4
June-2007
June-2008
June-2008
June-2009
June-2009
June-2010
June-2010
June-2011
June-2011
S&P Index
S&P Index
BarclaysBond
US Aggregate
Bond Index
Barclays US Aggregate
Index
Source: S&P and Barclays Index data. Both indexes are shown relative to their levels on June
30, 2007. Past performance not indicative of future results.
8
BMO Exchange Traded Funds
Asian Investment Grade USD Bonds – an Under Appreciated Asset Class
PAGE 6
It is worth noting that the strength of the correlation benefits
Correlations
tothat
US Bonds
What is clear in the chart
above is
Asian EM investment
over equities directly relates to the credit quality of bonds.
grade USD bonds have high correlations to US bonds.
In particular, investment grade bonds (i.e. high credit quality
This means that they have low correlations with US
bonds) have lower correlations with equities and are therefore
equities, demonstrated below, and as such offer significant
best suited for this purpose – bonds closer to the left in the
diversification benefits in investors’ portfolios.
0.80
0.40
0.20
0.00
diagram below will have better diversification benefits vs
(0.20)
holding only equities. In contrast high yield bonds, often
(0.40)
referred to as ‘junk bonds’ tend offer limited correlation
benefits vs equities.
BBB
-1
Low correlation to Equities
No correlation
European
US High EM Local
Union Euro- Yield Bonds Currency
Bonds
Bonds
Asia EM
Local
Currency
Bonds
EM USD
Bonds
Asia EM
Investment
Grade USD
Bonds
Correlation to US Equities
Correlations to US Equities
11
0.60
0.40
1
0.20
Perfect correlation to Equities
(Better)
EM
Equity
0.80
Junk bonds
0
Developed
Non-US
US Equities Equity
1.00
Correlation to equities
AAA
10
0.60
0.00
(Worse)
(0.20)
The message is that investors should not look at risk and
(0.40)
9
Asia EM
Investment
Grade USD
US Bonds Bonds
EM US$
Bonds
Asia EM European
Local Union EuroCurrency
Bonds
Bonds
EM Local
Currency
Bonds
US High
Yield
EM
Equity
Developed
Non-USD
Equity
return in isolation but also consider correlations. If the
objective is to select investments
diversification
Correlationthat
to offer
equities
Source: Barclays, MSCI, IBOX and S&P Index data. Correlations measured from October 2009
1.4
to May 2015 vs S&P500 Index. Past performance not indicative of future results.
1.3
correlations is appropriate. Or stated differently, if investors
1.2
Conclusion
benefits vs equites then selecting investments with low
want the diversification benefits that are offered by US bonds
in their portfolios, selecting investments with high correlation
to US bonds may be appropriate. The chart below shows the
correlation of several major asset classes to US bonds.
1.1
Investment
grade bonds provide investors a way to generate
1
recurring
income while reducing the overall risk level in
0.9
their0.8portfolios. Asian bonds may serve as another avenue
0.7
for investors
to augment returns from their bond holdings.
0.6 investors have a view on the direction of Asian market
Unless
0.5
currencies,
US dollar denominated Asian bonds are probably
0.4
Correlation to US Bonds
more
suitable for6/30/08
most investors.
In particular,6/30/10
investment
6/30/07
6/30/09
0.80
S&P Index
that are significantly higher
than US bonds with similar
0.60
credit quality and duration characteristics. The correlation
0.40
characteristics are also broadly similar to US bonds, and hence
0.20
they offer strong diversification benefits in a portfolio, yet offer
10
0.00
(0.20)
(0.40)
6/30/11
grade Asia ex-Japan bonds issued in US dollars provide yields
Correlations to US Bonds
Developed
Non-US
US Equities Equity
EM
Equity
European
US High EM Local
Union Euro- Yield Bonds Currency
Bonds
Bonds
Asia EM
Local
Currency
Bonds
EM USD
Bonds
Asia EM
Investment
Grade USD
Bonds
Source: Barclays, MSCI, IBOX and
S&P Index data.
are measured from October
Correlations
toCorrelations
US Equities
2009 to May 2015 vs Barclays US Aggregate Bond Index. Past performance not indicative of
1.00
future results.
0.80
0.60
0.40
0.20
0.00
(0.20)
(0.40)
1.4
Asia EM
Investment
Grade USD
US Bonds Bonds
EM US$
Bonds
Asia EM European
Local Union EuroCurrency
Bonds
Bonds
EM Local
Currency
Bonds
US High
Yield
EM
Equity
Developed
Non-USD
Equity
Barclays US Aggregate Bond Index
superior returns vs US bonds.
11
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