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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 BMO Exchange Traded Funds Contact us www.bmo.hk/etfs Important information: BMO Global Asset Management comprises BMO Asset Management Corp, BMO Asset Management Inc, F&C Asset Management plc, BMO Global Asset Management (Asia) Limited and BMO’s specialised investment boutiques: Monegy, Inc., Pyrford International Limited, LGM Investments Limited, and Taplin, Canida & Habacht, LLC. BMO Global Asset Management is part of the BMO Financial Group, a service mark of Bank of Montreal (BMO). The document is for informational purposes only in relation to the capabilities of BMO Global Asset Management. It should not be construed as an offer or solicitation to sell or buy any investment or to provide any services. While BMO Global Asset Management believes information contained within the document to be reliable, it gives no warranties or representations as to the reliability, accuracy and completeness of any such information. BMO Global Asset Management accepts no liability for any damage or loss, whether direct, indirect or consequential, in respect of any use of or reliance on the documents. The contents of the document have not been reviewed by any regulatory authority. Certain products and services offered under the brand name of BMO Global Asset Management are designed for specific categories of investors in a number of different countries and regions. These products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Global Asset Management (Asia) Limited is incorporated in Hong Kong and licensed by the Securities and Futures Commission of Hong Kong (CE No. ABA410) and has its registered office at 36/F and Suite 3808, One Exchange Square, Central, Hong Kong. It is not authorized or licensed in any other county in Asia to conduct any regulated activities. 10/15-2263 +852 3716-0990 [email protected]