Investigating International Corporate Bond Performance

Transcription

1 October 2014 CONTRIBUTOR Angana Jacob Global Research & Design Investigating International Corporate Bond Performance International corporate bonds are a large and liquid asset class with generally diversified exposure to interest rate movements, inflation cycles and the political or macroeconomic climate of different countries. Investors seeking diversification from their domestic exposure may allocate part of their portfolio to international equities. However, U.S.-based investors have historically overlooked both international government and corporate bonds, 1 although these two asset classes combined represent nearly 37% of global investable assets. 2 Incorporating a global approach to bond investing dramatically increases the size of the investment universe, providing a wider range of risk and yield. Since the main factors driving international corporate bond prices are relatively uncorrelated to the drivers of U.S. bonds and equities, they can potentially serve as a diversification tool in reducing the risks related to investing in domestic markets and also as a source of income in low-yield environments. In this paper, we look at the salient features of international corporate bonds, with a specific focus on investment-grade corporates issued in the G10 currencies (excluding U.S.-based issuers and U.S. dollar-denominated bonds). Our research shows that corporate bonds in different countries are subject to unique risk/return characteristics, performing uniquely in varying market environments. THE CHANGING LANDSCAPE OF THE INTERNATIONAL CORPORATE BOND MARKET In 2001, the global bond market was valued at a modest USD 37 trillion, with 94% of this value contributed by developed markets. Government/sovereign debt made up the majority of the total debt outstanding, and corporate issuance was significantly dominated by financials (financial issuance was almost twice the size of other categories). 3 Over the past decade, the landscape has changed significantly due to the substantial liberalization of global credit markets and the rapid growth of international debt issuance. From 2007 to 2013, the global debt universe rose by 43%, from USD 70 trillion to an estimated USD 100 trillion as of mid By comparison, the size of the global equity market is estimated to be USD 64 trillion Source: The determinants of domestic and foreign bond bias. Miguel A. Ferreira, Antonio F. Miguel. World investable assets comprise U.S. bonds (USD 40 trillion [SIFMA]), total debt outstanding (USD 100 trillion [BIS]) and the total equity market (USD 64 trillion [WFE]). According to the IMF 2001 bond report. According to the BIS quarterly review, June According to the World Federation of Exchanges, as of June 2014.

2 Governments have been the largest debt issuers in recent years, with accommodative monetary policy driving the huge increase in government spending. However, corporate bond markets have also grown tremendously and have almost tripled in size since Corporate issuance growth has not been uniform across sectors in developed markets; decreasing issuance from the financial sector since 2009 has been compensated by greatly increased nonfinancial firm issuance. 6 Bank lending has shrunk and corporates have rushed to take advantage of the lowest bond yields in the last 10 years. Investors ongoing search for yield is a key reason for the growing importance of corporate bonds as a significant fixed income alternative to government debt. Allocation to corporate bonds (both high yield and investment grade) has been increasing since the crisis among pensions from the U.K., Japan and Europe 6. There may be a further increase in bond demand, especially for long-dated corporates, as a larger number of defined benefit pension plans in developed markets move toward fully-funded status. While U.S. issuers have traditionally comprised the majority of the world s corporate bond markets, today U.S. corporates contribute only about one-quarter (see Exhibit 1). 7 In terms of currency, the non-u.s. dollar corporate debt market is now over one and one-half times the size of the U.S. dollar debt market, with corresponding investment opportunities. Exhibit 1: Breakdown of Outstanding Global Corporate Debt by Market 16,000 14,000 13,421 12,000 USD Bilions 10,000 8,000 6,000 7,143 5,147 4,000 2,000 2,275 1,685 1,023 1, Europe U.S. Japan China U.K. Canada Australia Emerging Markets Source: Bloomberg. Data as of June 30, Charts and tables are provided for illustrative purposes. 534 Frontier Markets CHARACTERISTICS OF INTERNATIONAL CORPORATE BONDS The total market capitalization of international bonds is larger than that of the U.S. equity, U.S. fixed income or international equity markets. In addition to providing exposure across multiple currencies, the corporate bond subset specifically provides investors with diverse opportunities across sectors and individual credit qualities (see Exhibits 2, 3 and 4). 6 7 Sources: NAPF 2013 DB Run-off: The demand for inflation linked assets, Mercer Report Asset allocation of Pension Funds around the world Feb 2014, J.P. Morgan report Japanese corporate pension funds adapt their investment strategies to Abenomics". Source: Bloomberg. Data as of June 30, Amount outstanding in USD billions. All data on amount outstanding from Bloomberg does not include the following forms of debt: U.S. agency, non-u.s. agency, preferred share, asset backed, mortgage backed, local authority, supranational, covered or money market. Emerging market data includes frontier markets unless explicitly shown. 2

3 Breakdown of International by Currency The largest contributor among the non-u.s. dollar currencies is the euro, accounting for 50% of the international corporate bond market (excluding U.S.-based issuers and U.S. dollar-denominated bonds). The U.K. follows, with a much lower contribution of approximately 30%. Exhibit 2: Breakdown of Outstanding Global Corporate Debt by Currency CAD EUR GBP NOK CHF JPY SEK AUD NZD Source: S&P Dow Jones Indices LLC. Data as of June Amount outstanding in USD billions. Excluding U.S.-based issuers and U.S. dollar-denominated bonds. Charts and tables are provided for illustrative purposes. Breakdown of International by Sector The yield levels and risk profiles of international corporate bonds differ depending on the economic sectors to which the issuer belongs. While financials have been the dominant sector among the corporate bond market historically, issuances by the sector have been decreasing since the 2008 financial crisis. In 2013, nearly 66% of global corporate bond issuances came from nonfinancial issuers, compared with 20% in In terms of amount outstanding, financials still represent a significant majority of the total market. Exhibit 3: Breakdown of Outstanding Global Corporate Debt by Sector Industrials Financials Healthcare Telecommunications Basic Materials Consumer Goods Consumer Services Oil & Gas Utilities Technology Source: S&P Dow Jones LLC. Data as of June Amount outstanding in USD billions. Excluding U.S.-based issuers and U.S. dollar-denominated bonds. Charts and tables are provided for illustrative purposes. 3

4 Breakdown of International by Credit Ratings International corporate bond markets are characterized by high quality, with nearly one-quarter of the global issuance rated AAA and 90% rated investment grade (BBB and above). 8 Historically, U.S. investment grade default rates tend to be significantly higher than European default rates. 9 Exhibit 4: Breakdown of Outstanding Global Corporate Debt by Credit Ratings AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- Source: S&P Dow Jones LLC. Data as of June Amount outstanding in USD billions. Excluding U.S.-based issuers and U.S. dollar-denominated bonds. Charts and tables are provided for illustrative purposes. BOND MARKET HISTORICAL PERFORMANCE The historical returns of fixed income markets around the world demonstrate the wide variability and lack of persistence in performance the country with the best performance in one year could be among the worst the next. Australian government bonds outperformed Japanese government bonds by more than 15% in 2008 but went on to underperform them significantly in The US has not been among the top-performing bond markets for most of the past 15 years, and the returns have been typically in the middle of the range. 8 9 Source: Bloomberg. Data as of June 30, Amount outstanding in USD billions. Source: National Bureau of Economic Research, Centre for Economic Policy Research, Standard & Poor s Ratings Services. Data as of February

5 Exhibit 5: Historical Performance of Government Bond Markets 35% 30% 25% 20% 15% 10% 5% 0% % -10% U.S. Europe U.K. Australia Japan Canada Emerging Markets South Africa New Zealand -15% Source: Bloomberg, EFFAS. Data as of June Bond performances of each country are represented by the respective Bloomberg or EFFAS government bond total return indices in USD. Past performance is no guarantee of future results. Index returns do not reflect expenses an investor would pay to replicate an index. International corporate bonds have provided significant investment opportunities over the last decade. Since 2000, there have been only two periods of negative returns: one during the financial crisis of 2008 and the other during the Eurozone sovereign crisis of 2010 and Although their correlations with U.S. and international equity rose, international bonds still outperformed equities in both crises. Exhibit 6: Total Return of Various Bond Markets Over Time Emerging Market Corporate U.S. Aggregate Global Aggregate Global Aggregate ex-u.s. U.S. Corporate High Yield G10 Investment Grade Corporate U.S. Investment Grade Corporate U.S. Treasury Source: Bloomberg. Data as of June Indices used to represent bond markets are: J.P. Morgan Corporate Emerging Markets Bond Index, Barclays U.S. Aggregate Bond Index, Barclays Global Aggregate ex-u.s. Bond Index, S&P U.S. Issued High Yield Corporate Bond Index, S&P U.S. Issued Investment Grade Corporate Bond Index, S&P/BGCantor U.S. Treasury Bond Index, S&P International Corporate Bond Index. Past performance is no guarantee of future results. Index returns do not reflect expenses an investor would pay to replicate an index. 10 Performance based on the S&P International Corporate Bond Index. 5

6 Exposures to credit, interest rate, currency, and liquidity risk give international corporate bonds a different risk/return profile than other asset classes, as demonstrated in Exhibit 7. Exhibit 7: Return Versus Risk Across Various Asset Classes Return 11.00% 10.00% 9.00% 8.00% 7.00% 6.00% U.S. Investment Grade U.S. Corporate High- Yield Emerging Markets Global Aggregate (ex-u.s.) Global Aggregate 5.00% U.S. Aggregate 4.00% 3.00% 5.00% 7.00% 9.00% 11.00% 13.00% 15.00% 17.00% 19.00% Risk Source: Bloomberg. Data from 2003 to Indices used to represent markets are: S&P 500, MSCI EAFE Index (TR), J.P. Morgan Corporate Emerging Markets Bond Index, J.P. Morgan Government Bond Index-Emerging Markets, Barclays U.S. Aggregate Bond Index, Barclays Global Aggregate ex-u.s. Bond Index, S&P U.S. Issued High Yield Corporate Bond Index, S&P U.S. Issued Investment Grade Corporate Bond Index, S&P/BGCantor U.S. Treasury Bond Index, S&P International Corporate Bond Index. Past performance is no guarantee of future results. Index returns do not reflect expenses an investor would pay to replicate an index. POTENTIAL DIVERSIFICATION BENEFITS G10 Investment Grade Emerging Markets Government U.S. Treasury U.S. Equities International Equities (ex- U.S.) In addition to providing income, reducing overall portfolio volatility is generally one of the key goals of fixed income investing. With the current low yields in U.S. Treasuries, investors may look to other alternatives to accomplish diversification while minimizing the loss of yield. Traditionally, U.S. based investors considered international stocks as a way to diversify their domestic equity exposure. However, the correlation between international equities and U.S. stocks over the past decade was around 94%. In comparison, the correlations between international bonds with U.S. bonds and equities are much lower. Exhibit 8: Correlation Between G10 Investment Grade (Unhedged) and Other Asset Classes 70% 60% 50% 40% 30% 20% 10% 0% U.S. Equities International Equities (ex-u.s.) Emerging Market U.S. High-Yield U.S. Investment Grade U.S. Treasury Source: Bloomberg. Data from 2003 to Indices used to represent markets are: S&P 500 (TR), MSCI EAFE Index (Net TR), J.P. Morgan Corporate Emerging Markets Bond Index, S&P U.S. Issued High Yield Corporate Bond Index, S&P U.S. Issued Investment Grade Corporate Bond Index, S&P/BGCantor U.S. Treasury Bond Index. Charts and tables are provided for illustrative purposes. 6

7 Domestic, high-grade bonds tend to behave similarly because they are driven by the same domestic policies and interest rate movements. On the other hand, international bonds may offer exposure to many countries that are not at the same point in their economic cycles. Due to differences in resource allocation and monetary and fiscal policies, the interest rate and inflation cycles of one country can be quite distinct from another (see Exhibit 9), which could provide a diversification benefit and a corresponding reduction in risk. Though the bonds of a particular country could be more volatile than their U.S. counterparts, investing broadly in bonds across countries, sectors and maturities could potentially provide the benefit of the varying correlations between them and could lower overall portfolio volatility (if the bond returns are currency hedged). In addition, exposure to a wide and varied set of bonds may appear to be a better alternative when considering the difficulty of determining which segment of the bond market could outperform at any point in time. Exhibit 9: Interest Rates and Inflation in Select Countries Country Interest Rates (%) Inflation (%) Australia Canada China Denmark Eurozone Sweden Germany Japan South Africa U.K U.S Spain Source: TradingEconomics. Data as of June Charts and tables are provided for illustrative purposes. Following the 2008 financial crisis, government bond performances in the developed markets have tracked each other closely due to similar monetary policies being enacted by the major global central banks. In such an environment, investors looking for meaningful diversification are forced to go beyond government bonds and into corporate investment-grade and high-yield bonds, which are driven by additional non-systemic factors. To illustrate the potential diversification benefit of adding international corporate bonds to a stylized portfolio, we look at varying asset allocations between U.S. equities, international equities, U.S. bonds and international bonds over the same 10-year period. The data show that incorporating international corporate bonds in the allocation mix could potentially increase overall returns and also produce a slightly better risk-adjusted return. Exhibit 10: Returns and Volatility of Various Portfolio Allocations Metric 30% U.S. Equity 30% Intl. Equity 20% U.S. 20% Intl. 30% U.S. Equity 30% Intl. Equity 0% U.S. 40% Intl. 60% U.S. Equity 0% Intl. Equity 20% U.S. 20% Intl. 60% U.S. Equity 0% Intl. Equity 0% U.S. 40% Intl. 60% U.S. Equity 0% Intl. Equity 40% U.S. 0% Intl. Total Return (%) Risk (%) Return-Risk Ratio Source: S&P Dow Jones Indices LLC. Data from 2003 to June 30, Indices used to represent markets are: S&P 500 (TR), MSCI EAFE Index (Net TR), S&P U.S. Issued Investment Grade Corporate Bond Index, S&P International Corporate Bond Index. Past performance is no guarantee of future results. Index returns do not reflect expenses an investor would pay to replicate an index. 7

8 Though the performance of international bonds is diverse over the long term, investors must keep in mind that in adverse market conditions, anticipated correlation benefits may not materialize, especially over shorter time periods. In periods of heightened risk aversion, international bonds and equities typically experience sell-offs, with a flight to safer assets such as U.S. Treasury bonds, the U.S. dollar or the yen. During the financial crisis of 2008 and the Eurozone sovereign crisis of 2011, portfolios with an allocation to international bonds were more volatile than portfolios with only domestic exposure, and they produced lower returns. RISK CONSIDERATIONS FOR INTERNATIONAL CORPORATE BONDS Common risks associated with investing in fixed income securities include interest-rate risk, reinvestment risk, call risk, credit risk, inflation risk, liquidity risk and currency risk. International corporate bonds, in particular, are susceptible to interest rate risk, credit risk, currency risk and liquidity risk. Interest Rate Risk With the prospect of global recovery and the probability of interest rates eventually rising upward toward historical averages, investors are increasingly concerned about the duration risk in their fixed income allocations. Similar to long-term government bonds, long-term corporate bonds are usually affected negatively during monetary tightening, although their yields tend to increase by less than government bond yields of comparable maturities.11 Investment-grade bonds typically have shorter maturities than government bonds and, by definition, lower duration. Despite this, duration risk is still the principal driver of their performance, and it is generally much higher than their credit risk 12. It is important to note that though rising rates will negatively affect the price return of a bond, the total return which combines both income and price return, is a more accurate measure of the overall bond performance. Income from bonds, especially over the long term could help offset their duration-related price decline and thus protecting their overall return. In the last 70 years, the rising rate periods of , , , , , and exhibited differing impacts on bond returns. During periods of incrementally rising rates spanning long periods, the total return of corporate bonds may be positive, as demonstrated in the most recent rising rate environment spanning 24 months from (see Exhibit 11). If central banks prefer to be late rather than early to hike rates, a period of increasing rates may still allow positive fixed income returns, if the overall pace is slow. The varied performances during different periods are also dependent on other environmental conditions in each case, such as the magnitude of the increase, the starting yield environment, and the steepness of the yield curve. Even a slow rate increase could be devastating to bond holders if it is from a low starting yield, as was seen during , when rates increased by a total of only 2% over 70 months, but drawdowns reached almost - 15%. In an environment of low yields and tight credit spreads, the cushion to protect the total returns of highquality bonds is comparatively low. As economies improve during a recovery, with increasing business and consumer confidence, it may be beneficial for investors to trade some exposure from duration risk to credit risk in order to add value. 11 Source: Longstaff, Francis A., and Eduardo S. Schwartz, A Simple Approach to Valuing Risky Fixed and Floating Rate Debt, Journal of Finance, 50, Source: Fitch. The Bond Bubble : Risks and Mitigants, Using a stylized BBB corporate bond (with a 3.5% coupon and a maturity of 10 years) as an example, this article illustrates that even a relatively moderate rate increase could result in market-value losses that far exceed credit losses in a severe default risk scenario. 8

9 Exhibit 11: Bond Market Performance During the Rising Interest Rate Period 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Source: Bloomberg. Data based on total returns in USD. Data from June 2004 to June Indices used to represent markets are: S&P 500 (TR), MSCI EAFE Index (Net TR), J.P. Morgan Corporate Emerging Markets Bond Index, S&P U.S. Issued High Yield Corporate Bond Index, S&P U.S. Issued Investment Grade Corporate Bond Index, S&P/BGCantor U.S. Treasury Bond Index. Past performance is no guarantee of future results. Index returns do not reflect expenses an investor would pay to replicate an index. Credit Risk Emerging Market Government Emerging Market Corporate U.S. Aggregate Global Aggregate U.S. Corporate High-Yield G10 Investment Grade Corporate U.S. Investment Grade Corporate U.S. Treasury International bond markets provide various levels of yield and maturities to match an investor s liability profile (see Exhibit 12). Investors looking for better yields could either increase their duration exposure or move down the credit quality spectrum. Corporate bonds usually provide higher yields, with the spread reflecting the compensation for additional credit risk required by investors to hold the corporate bond instead of the arguably less risky government bond. In cases when government debt provides negative real yield (yield below inflation), as is the case in most developed markets, investment grade corporate bonds (though likely suffering from similar yield compression) may still offer positive real yields and a higher compensation per unit of duration as compared with government bonds. Additionally, the corporate spread is less sensitive to rate changes than government bonds and can provide a cushion against price depreciation when interest rates eventually start to rise. Moving even further from investment grade credit to high-yield bonds could generate additional yield pickup, but this may shift the risk profile by taking on increased credit risk and producing more equity-like returns. The yield on developed market bonds is not generally as compelling as emerging market bonds or high-yield debt, but at the same time these bonds are usually less vulnerable to sell-offs and global risk aversion, as was seen in mid and the beginning of Investors in emerging market bonds should look carefully at the impact of tapering and the poorer liquidity in addition to the fundamentals of the emerging market economies. 9

10 Exhibit 12: Yield and Duration Trade Off 6 5 Global High-Yield Emerging Market Yield to Worst AUD Investment Grade G10 Investment Grade EUR Investment Grade JPY Investment Grade GBP Investment Grade AUD Treasury USD Investment Grade CAD Investment Grade U.S. Aggregate U.S. Treasury Global Aggregate Global Treasury Japanese Sovereign Duration Source: Barclays, Bloomberg. Data as of June Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results. Currency Risk A possible reason to own international bonds is to gain exposure to potentially appreciating foreign currencies and to serve as a hedge against U.S. dollar weakness. The currency component of an international bond could, in many cases, dwarf the effect of changes in the bond s yield. For example, Japanese bonds are generally characterized by extremely low yields, however investors could benefit from a rising yen. In the case of unhedged bonds, the impact of currency volatility can be significant and even overwhelm the positive benefits of diversification and skew the risk profile of the bond portfolio. Exchange rate risk has been seen to dominate overall figures, contributing up to 95% of the total unhedged return volatility of a bond portfolio Source: IMF Working paper - Currency Hedging for International Portfolios, June

11 Exhibit 13: Volatility Across Foreign Exchange Spot Rates and U.S. 30% 25% EUR-USD Exchange Rate 20% 15% GBP-USD Exchange Rate 10% JPY-USD Exchange Rate 5% 0% Source: Bloomberg. Data from 1999 to U.S. Aggregate represented by Barclays U.S. Aggregate Bond Index. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results. Nearly 30% of the return from unhedged international corporate bonds since 2001 has come from holding foreign currencies that have gained versus the U.S. dollar.14 Because local currency bonds are closely tied to their countries fiscal, monetary and macroeconomic policies, the currencies can offer an additional layer of diversification benefits because they are driven by some factors that are relatively uncorrelated to both each other and to global credit risk factors. Exhibit 14: Percentage Correlations Between Various Currency Spot Rates and Other Asset Classes U.S. Aggregate USD IG Corp. G10 IG Corp. USD Spot GBP Spot EUR Spot JPY Spot AUD Spot CAD Spot S&P 500 USD IG Corp G10 IG Corp USD Spot GBP Spot EUR Spot JPY Spot AUD Spot CAD Spot S&P Source: Bloomberg. Data as of June Charts and tables provided for illustrative purposes. However, investors need to keep in mind that the last 13 years have witnessed the broad decline of the U.S. dollar, along with falling interest rates. If the U.S. dollar appreciates on the basis of better economic growth and the Fed s tapering, investors could have added portfolio risk through currency volatility and yet still receive poor currency returns that could negate bond yields. Low correlations between currencies and equities or bonds are also not stable over time, especially in conditions of market turbulence. 14 The annualized return from holding foreign currency versus the U.S. dollar in the same period, as calculated from the U.S. dollar index, is 2.3% or 28.5% of the total annualized return from international corporate bonds (the remaining 71.5% of the return is due to intrinsic corporate bond risks). 11

12 Exhibit 15: U.S. Dollar Index Source: Bloomberg. Data as of June Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results. Liquidity Risk An important characteristic of corporate bonds is their lower liquidity when compared with government debt. The corporate bond market is highly fragmented, with smaller issuance sizes, making it more susceptible to a potential shortage in liquidity. This is a non-negligible risk for developed market corporate bonds, and it is only amplified in the case of emerging markets with the increased risk reflected in their higher yields. Although issuance is at record levels under favorable borrowing conditions, corporate bond turnover in secondary markets has been decreasing since the financial crisis, with banks cutting back on providing liquidity as a result of new regulations. In the case of a distressed market environment, investors may find exiting corporate bond holdings difficult. CONCLUSION In low-rate environments, investors face a difficult situation as they try to protect their fixed income portfolio from potentially rising rates. Corporate bonds represent a viable alternative to government bonds, and the international corporate bond sector can provide needed income as well as an opportunity to enhance a portfolio s diversification and risk-adjusted returns. With the growth of global bond markets in recent years, a wider opportunity set is available for investors looking beyond their domestic market to obtain broad exposure to various corporate sectors as they seek income opportunity and long term diversification. 12

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