Strength in Diversity: The Case for Investing in Global Fixed Income

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1 Investment Focus Strength in Diversity: The Case for Investing in Fixed Income A well-managed allocation to global fixed income can play an important role in an investor s portfolio. The world economy, despite turbulence over the past several years, continues to grow and evolve, offering opportunities to rotate through interest rates, credit, and currency markets. A skilled manager can improve a total portfolio s risk-return profile through skilled security selection, investing in low-correlated and unsynchronized markets, and adding value through currency management.

2 2 Introduction: The Opportunity in The global fixed income market has grown rapidly over the past two decades. Today, the Barclays Capital Aggregate Bond Index is more than twice the size of its US counterpart. An allocation to global bonds, both listed and unlisted, can offer a number of advantages over an allocation to a single-country index, including: Higher potential returns from an expanded country and credit universe; Return diversification based on multiple interest rate and economic environments; Flexibility through active management to potentially avoid benchmark concentration risk while accessing out-of-benchmark opportunities; Enhanced returns through currency management. fixed income positions should be carefully managed both at the security level as well as in regard to their relationship to the rest of the portfolio. While some global bonds offer higher yields, they often reflect greater, or different, risk. At Lazard, our global fixed income strategies integrate macro market and trend analysis with bottom-up security research. Our goal is to combine the traditional benefits offered by domestic fixed income with the opportunity to capture higher returns. Home Alone Home-country bias can result in missed opportunities. An investor who holds the bonds of just one country is tied to its economic cycle, inflation, yield curve, and monetary policy. With global bonds, however, the investor can diversify exposure to different drivers of performance. For example, as the US Federal Reserve is expected to start raising rates in the near future, many other central banks of both large and small countries will likely remain accommodative for some time. While global capital markets are integrated and some macro factors may have an impact across countries, these factors typically diverge over different time horizons. An investor with a local concentration would be unable to benefit from favorable results elsewhere. In the past two decades, for example, US bonds were the lead performers just three times in a group of 11 nations (Exhibit 1). Investing globally in fixed income significantly broadens the opportunity set. The Barclays Capital Aggregate Bond Index with 16,000 issues and a market value near $43 trillion has almost twice as many securities and is nearly two-and-a-half times the market value of the Exhibit 1 There Are Different Winners and Losers Every Year Local Currency Performance of Select Countries in the Citigroup World Government Bond Index Sweden Italy Japan Canada Norway Sweden Australia Italy Italy Italy Italy Canada Sweden Italy Norway Australia Italy Australia Italy Canada Canada France France Japan Australia France Australia Sweden Italy Canada France Canada Sweden Norway Germany Australia Australia Australia France Canada Canada France Canada France Sweden Norway Italy Australia Germany Canada Sweden Norway Sweden Italy Australia Italy Canada Sweden Norway France France Germany Australia Sweden Norway Germany France Australia France Sweden Germany Germany Germany Italy Australia France Australia Germany Japan France Germany Germany Norway Norway Australia Germany Germany Germany Canada Germany Japan Japan Canada Australia Canada Norway Germany Norway Germany France Australia France Australia Sweden Australia Sweden Norway Germany France Sweden Norway Norway Canada Canada Germany Canada Sweden Italy Japan Norway Norway Germany Sweden Norway Canada Sweden France Canada Japan Japan Japan Norway Italy Norway Canada France France Italy Australia Japan Japan Japan Sweden Germany Japan France Japan Sweden Japan Japan Japan Japan Italy Italy Japan Italy Italy Sweden Japan As of 31 December 2014 The table shows annual total returns of 11 major components of the Citigroup World Government Bond Index Unhedged (WGBI Unhedged), in local currency terms. The WGBI Unhedged covers the most significant and liquid government bond markets, currently including 23 government bond markets, worldwide. Credit: Callan Associates Inc. and the Callan Periodic Table of Investment Returns. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. For illustrative purposes only. This information is not representative of any product or strategy managed by Lazard. Source: Citigroup

3 3 Barclays Capital US Aggregate Bond Index. 1 This wide choice of investments including both developed and emerging markets is especially important today given the fluid global macro landscape. In addition, the global bond market is much larger than what is listed in the indices and therefore offers skilled investors even more opportunities. The return pattern of global bonds is different from US bonds, which can provide diversification benefits in a total bond context and relative to other assets. Historical correlations of global bonds versus US and global developed markets equities show that global bonds have maintained diversifying characteristics (Exhibit 2). bond performance, hedged back to US dollars, also provides diversification benefits as it tracks US bonds over many periods, but with lower volatility. Benefits of Active Management Countering Benchmark Drawbacks While more and more investors are considering passive vehicles for their investments, we believe active management may be the most effective way to access global fixed income. Because passive indices are capitalization weighted, the bigger (i.e., more indebted) issuers have the larger weights. More than one-third of the Barclays Capital US Aggregate, for example, was represented by US Treasuries as of March Investors in vehicles that match this index are thus taking on significant exposure to US Treasuries, which may be an unwanted concentration. The significant amount of US Treasuries in the Barclays Capital US Aggregate is a result of issuance in recent years, and it is an important reminder that bond benchmark characteristics are not static. Since the onset of monetary easing, benchmark yield and duration have moved in virtually opposite directions. That is, yields have trended lower while duration has become longer. For investors, this means more interest rate sensitivity and less compensation via income. This is potentially a dangerous proposition in today s low-rate environment. An active approach to global bond investing can help counter many drawbacks in benchmarks. Active managers can diversify country/sector exposure to avoid undesirable concentrations that can arise from capitalization weighting. Interest rate risk can be dampened through careful duration and yield curve management at a local country level. Managers can also potentially add value through out-of-benchmark securities and take into account a security s potential characteristics, such as liquidity, that a passive index cannot. In addition, passive vehicles often cannot replicate benchmarks because some securities may not be widely available or suitable for investors. Expanded Credit Opportunities As we already noted, the global bond market is much larger than what is represented in the indices. Generally, benchmark-eligible issue size must be at least $500 million, which excludes a substantial number of potentially attractive bond issues. Considering securities outside of the benchmarks can significantly expand the number and types of opportunities available to managers. Credit, or non-government bonds from around the world have increased in importance as issuance has flourished over the past decade in sectors such as corporates, sovereign external debt, supranationals, agencies, and mortgages. An investor s ability to focus on global credit cycles and exploit mispriced credit spreads at the country and currency level is another tool that can potentially add value compared to a credit strategy that is purely Exhibit 2 Can Provide Diversification Benefits Relative to Other Asset Classes Correlation of Bond Indices, US, and : January 2000 April 2015 (Hedged) 1.00 (Hedged) US US US US = Barclays Capital Aggregate Bond Index (Hedged) = Barclays Capital Aggregate Bond Index (Hedged USD) US = Barclays Capital US Aggregate Bond Index = MSCI World Index US = S&P 500 Total Return Index Data in US dollars. MSCI World Index includes dividends net of withholding tax. The performance quoted represents past performance. Past performance does not guarantee future results. Diversification neither assures profit nor protects against losses in declining markets. Source: Barclays, Bloomberg, MSCI, Standard & Poor s Exhibit 3 Credit Opportunities Are GE Offer Different Characteristics in Different Parts of the World. Five-Year Maturity GE Bond Spreads vs. Local Government (bps) Japan Mexico Europe Canada Australia Sweden As of 24 August 2015 Data show the option-adjusted spread. The securities mentioned are not necessarily held by Lazard for all client portfolios, and their mention should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio. Source: Bloomberg domestic. For example, the characteristics offered by GE bonds can vary in different parts of the world (Exhibit 3). An additional benefit from a larger opportunity set may be enhanced income, as skilled security selection can increase a portfolio s current yield relative to a benchmark. This is especially important given the downward pressure on yields in recent years.

4 4 The Currency Question fixed income has exposure to foreign currencies in fact, the volatility from bond components (price and coupon) is small compared to the volatility from currency fluctuations. As a result, many observers believe that global bond strategies should be hedged from a currency perspective. In our view, however, unhedged versions may also be well suited for investors if they are carefully managed. In a lowyield environment, currency exposure can actually add value over full market cycles. On a rolling three-year return basis, unhedged and hedged index performance vary over different market cycles. These fluctuations may provide opportunities within a global fixed income context especially related to currency exposure and cycles (Exhibit 4). In our analysis, the unhedged version actually outperformed the hedged version in about 58% of the monthly observations (each reflecting a three-year rolling return result) since Investors may be influenced by the strong dollar trend in 2014 and early 2015, but we believe the cycle will ultimately shift again, providing opportunity to profit from currency exposure. Active managers have more opportunities to add value compared to passive managers and, importantly, indices do not reflect transaction costs, which can be a significant drag on performance over the long term. A benchmark s currency exposure is driven by its country weights, which cannot be altered by passive investors. In hedged indices, the hedging methodology is also passive. In contrast, an active manager can tailor the strategy s currency exposure and find unique ways to add value providing the ability to be both defensive and opportunistic. Our Approach Lazard manages global fixed income strategies with the goal of enhancing returns by rotating through global bond and credit markets, and taking currency risk when appropriate. As an active manager, we conduct global macro-market and trend analysis, and we research individual securities using a rigorous bottom-up credit process. Our investment framework identifies six broad sources of returns: country allocation, yield curve positioning, duration exposure, sector allocation, security selection, and currency exposure. These sources are systematically integrated into our portfolio construction process. We can be flexible and tactical, by continually assessing the market environment from a global and local perspective, taking into account the impact of capital flows, market positioning, and investor sentiment. We also monitor relative values from a global perspective (interest rate, credit, and currencies), and unique nuances and factors that drive asset prices for each country. We avoid what we believe are overcrowded or consensus ideas, and seek opportunities that other investors may be overlooking. If our view of an individual security is not constructive, we will not invest in it regardless of its inclusion in a benchmark. Before implementing any trades, we perform qualitative research (i.e., liquidity, market positioning) and quantitative analysis (i.e., scenario and break-even analyses, correlations) to fully understand and monitor risk in the portfolios. Exhibit 4 Active Managers Can Take Advantage of Changing Market Leadership Rolling 3-Year Performance, Unhedged minus Hedged (%) Unhedged Outperforms Hedged Outperforms As of 31 July 2015 Data time period from January 1993 to July Unhedged = Barclays Capital Aggregate Bond Index; Hedged = Barclays Capital Aggregate Bond Index (Hedged USD). The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices above are unmanaged and have no fees. One cannot invest directly in an index. Not intended to represent any product or strategy managed by Lazard. Source: Bloomberg Our portfolios are constructed with cash bonds. We think this is an important differentiator for many investors, as implementations with derivatives can introduce basis and counterparty risk. The universe, or opportunity set, for our strategies is unconstrained and applies to both absolute and relative return mandates. An absolutereturn orientation relates to how we think about risk management, or risk calibration, which may differ from our relative return mandates. Essentially, an absolute return mandate is designed to produce a positive return regardless of market conditions. Therefore, we believe it is critical to understand the various layers of risk within the context of risk control. For example, we utilize stop losses on currency exposures since currencies are generally the largest source of volatility for a global fixed income portfolio. Maintaining a shorter duration, or more defensive interest rate profile, may also be part of our risk management process in today s volatile rate environment, as is monitoring and managing sector/spread risk. Depending on the market environment, the portfolio holdings and positioning may not necessarily differ from a relative return mandate, but risk management will likely be very different. We believe that investors should not lose sight of the role that fixed income can play within a total portfolio, especially during periods of risk aversion. Some unconstrained fixed income strategies carry the risk that the performance pattern may vary significantly from a traditional diversified fixed income portfolio. These strategies are often exchanging interest rate risk for credit risk, with an increasing correlation to the equity market. Interest rate risk (in a rising rate environment) can be considered an opportunity cost. With credit risk, however, a credit event could lead to capital impairment, which has the potential for a significant loss. Unlike some unconstrained fixed income strategies, our approach is focused on diversification, while rotating through global interest rate, credit, and currency markets.

5 5 Conclusion We believe that active global fixed income investing offers the potential to improve a portfolio s risk/return profile and act as a diversifier to other asset classes, the possibility to invest in low-correlated and unsynchronized markets, and the ability to add value through currency management. Compared to a strictly domestic portfolio, a global allocation has a larger opportunity set and has exposure to several economic and interest rate cycles, potentially raising the likelihood that skilled managers can help investors meet their goals over the long term. Notes 1 As of March 2015 Important Information Published on 28 September Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of 17 September 2015 and are subject to change. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as junk bonds ) inherently have a higher degree of market risk, default risk, and credit risk. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. Derivatives transactions, including those entered into for hedging purposes, may reduce returns or increase volatility, perhaps substantially. Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. Use of derivatives transactions, even if entered into for hedging purposes, may cause losses greater than if an account had not engaged in such transactions. Investments in global currencies are subject to the general risks associated with fixed income investing, such as interest rate risk, as well as the risks associated with non-domestic investments, which include, but are not limited to, currency fluctuation, devaluation, and confiscatory taxation. Furthermore, certain investment techniques required to access certain emerging markets currencies, such as swaps, forwards, structured notes, and loans of portfolio securities, involve risk that the counterparty to such instruments or transactions will become insolvent or otherwise default on its obligation to perform as agreed. In the event of such default, an investor may have limited recourse against the counterparty and may experience delays in recovery or loss. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) and sources believed to be reliable as of the publication date. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance does not guarantee future results. This document is for informational purposes only and does not constitute an investment agreement or investment advice. References to specific strategies or securities are provided solely in the context of this document and are not to be considered recommendations by Lazard. Investments in securities and derivatives involve risk, will fluctuate in price, and may result in losses. Certain securities and derivatives in Lazard s investment strategies, and alternative strategies in particular, can include high degrees of risk and volatility, when compared to other securities or strategies. 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