Global bond investing Todd Schlanger, CFA Investment Strategy Group Vanguard Asset Management, Limited This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Vanguard s economic and market outlook Growth: Inflation and interest rates: Asset returns: World: Frustratingly fragile U.S.: Remains resilient with slightly above 2%-trend growth, but not immune to poor outlook overseas Europe: Still very weak, but improving outlook fueled by QE, Euro weakness and oil prices China: Permanently slower, but hard landing unlikely Japan: Growth rebound constrained by VAT. Should fall short of Abenomics goals Global deflationary pressures continue, but stable oil prices and global QE should help U.S. wage growth should rise, but strong dollar may keep inflation < 2% for some time Fed to liftoff: Likely 2015, but slower and lower, with pause around 1% possible A marked rise in global bond yields unlikely Divergent monetary policies: ECB and BoJ may not raise rates this decade A marked rise in global bond yields unlikely; risk premiums remain compressed Credit and equity risk may be higher than duration risk Outlook for equity risk premium remains formative; central tendency of 6% 8% nominal 10-year returns In near term, equity returns biased lower Lowest projected expected returns since 2006 for balanced portfolios 2
Projected global fixed income ten-year return outlook VCMM-simulated distribution of expected average annualized return of the global fixed income market, estimated as of March 2014 and March 2015 Probability 25% 20% 15% 10% Global bond returns 1926 2015 5.4% 1926 1969 3.1% 1970 2015 7.8% 2000 2015 5.4% 5% 0% Less than 1% 1 to 1.5% 1.5 to 2% 2 to 2.5% 2.5 to 3.0% 3.0 to 3.5% 3.5 to 4.0% 4.0 to 4.5% More than 4.5% 10-year Annualized Return Current 10-year outlook Outlook as of March 2014 IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM, derived from 10,000 simulations for global equity returns and fixed income returns in USD. Simulations as of March 31, 2015. Results from the model may vary with each use and over time. For more information, please see the Important information slide. Note: Figure displays projected range of returns for a portfolio of 70% U.S. bonds and 30% ex-u.s. bonds, rebalanced quarterly. For details, see Vanguard s economic and investment outlook (Davis, Aliaga-Diaz, Patterson, and Ahluwalia 2014). Source: Vanguard. 3
Divergent policy rate expectations Policy rate expectations: Gradual tightening and more loosening 2.5 2.0 1.5 Percent (%) 1.0 0.5 0.0-0.5 2012 2013 2014 2015 2016 2017 2018 2019 United States United Kingdom Eurozone Japan Notes: Dotted lines are forward curves estimated using overnight index swap rates available on 5 October, 2015. Sources: Vanguard calculations based on data from Bloomberg. 4
What happens to a bond when rates increase? Annual Return of a 10-year Gilt if the forward curve is realised 4% 3% Return contribution 2% 1% 0% -1% -2% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Price Return Income Return Total Return Source: Vanguard, based on data from the Bank of England. Notes: Displays the characteristics of a 10-year gilt investment, assuming the yield curve evolves following the forward curve derived from the 31 June 2015 spot curve. Assumes a 10 year gilt is purchased at the beginning of the year, held for 1 year, then sold, with the proceeds re-invested in another 10-year gilt. 5
Fearful of rising interest rates? Consider a more global bond portfolio Correlation of quarterly changes in government bond yields, January 1970 December 2013 1.00 0.41 0.43 0.28 0.42 0.45 0.31 0.32 0.36 0.46 0.27 0.29 0.42 0.37 0.37 0.48 0.41 1.00 0.43 0.28 0.73 0.60 0.40 0.49 0.39 0.60 0.25 0.44 0.56 0.53 0.43 0.48 0.43 0.43 1.00 0.30 0.49 0.51 0.27 0.30 0.40 0.53 0.03 0.28 0.33 0.45 0.42 0.78 0.28 0.28 0.30 1.00 0.32 0.28 0.18 0.27 0.18 0.32 0.10 0.19 0.31 0.22 0.20 0.28 0.42 0.73 0.49 0.32 1.00 0.60 0.43 0.49 0.43 0.61 0.15 0.44 0.54 0.51 0.45 0.51 0.45 0.60 0.51 0.28 0.60 1.00 0.43 0.33 0.49 0.83 0.14 0.34 0.44 0.63 0.50 0.60 0.31 0.40 0.27 0.18 0.43 0.43 1.00 0.31 0.29 0.30 0.06 0.18 0.27 0.33 0.67 0.25 0.32 0.49 0.30 0.27 0.49 0.33 0.31 1.00 0.18 0.35 0.19 0.24 0.46 0.28 0.29 0.24 0.36 0.39 0.40 0.18 0.43 0.49 0.29 0.18 1.00 0.48 0.11 0.06 0.28 0.39 0.34 0.42 0.46 0.60 0.53 0.32 0.61 0.83 0.30 0.35 0.48 1.00 0.18 0.31 0.41 0.65 0.39 0.60 0.27 0.25 0.03 0.10 0.15 0.14 0.06 0.19 0.11 0.18 1.00 0.17 0.35 0.12 0.08 0.09 0.29 0.44 0.28 0.19 0.44 0.34 0.18 0.24 0.06 0.31 0.17 1.00 0.47 0.42 0.30 0.25 0.42 0.56 0.33 0.31 0.54 0.44 0.27 0.46 0.28 0.41 0.35 0.47 1.00 0.40 0.34 0.35 0.37 0.53 0.45 0.22 0.51 0.63 0.33 0.28 0.39 0.65 0.12 0.42 0.40 1.00 0.44 0.45 0.37 0.43 0.42 0.20 0.45 0.50 0.67 0.29 0.34 0.39 0.08 0.30 0.34 0.44 1.00 0.39 0.48 0.48 0.78 0.28 0.51 0.60 0.25 0.24 0.42 0.60 0.09 0.25 0.35 0.45 0.39 1.00 Notes: Each cell displays the average correlation of quarterly changes in the long-term government bond yield of one country relative to the yield of each other country. The cells are shaded according to the magnitude of the correlation, as noted in the key. The countries shown reflect the largest developed government bond markets with monthly historical yield data available since 1970. Data is to the latest available as of 31 December 2013. Sources: Vanguard, using data from International Monetary Fund. From Vanguard research paper Fearful of rising interest rates? Consider a more global bond portfolio by Philips and Thomas, 2013. 6
Global diversification can help diversify interest rate risk Cumulative total return during periods of rising 10 year gilt yields 5% 4% 3% 2% 1% +84bps +81bps +136bps +92bps Yield increase 4.1% 3.7% 3.3% 2.3% 2.3% 0.6% 0% -1% -2% -3% -1.8% January 1999 to January 2000 May 2003 to July 2004 January 2006 to June 2007 May 2012 to December 2013-2.4% Global Market (hedged) Sterling Market Sources: Vanguard, using data from Barclays Capital as of 31 December 2013. Notes: Global market is represented by Barclays Global Aggregate Index hedged and the UK market is represented by the Barclays Sterling Aggregate Index. 7
Global fixed income is multi-dimensional Core Specialty Composition of major components of global fixed income market, December 2014 84% Investment-grade 4% High-yield 5% Inflation-linked 7% Emerging market 67% Government 16% Corporate 17% Securitised Breakdown of investment grade sector 24% 1-3 years 20% 3-5 years 17% 5-7 years 18% 7-10 years 21% 10+ years 43% US dollar 26% Euro 15% Yen 6% Sterling 3% Canadian dollar 1% Australian dollar 5% Other Source: Barclays as of December 31, 2014. Differences due to rounding. Notes: Displays the percentage of the Barclays Global Aggregate Index by various sector, according to index composition. 8
Cash flows favouring higher yielding and non-traditional assets Cumulative 12-month cash flow into Investment Association sectors to July 2015 10 8 6 Billions 4 2 0-2 Absolute return Property UK Equity Income Global Equity Income Money Market Flexible Investment UK Equity & Bond Income High Yield UK Gilts Global EM Bonds Global Bonds UK Index Linked Gilts Corporate Bond Strategic Bond Source: Vanguard calculations, using data from Morningstar, Inc. Data as of 31 July, 2015. 9
High quality bonds remain a good diversifier Cumulative return during the global financial crisis, 12 October 2007 to 9 March 2009 30% 20% 10% 10% 14% 18% 0% -10% -20% -30% -40% -50% -60% -37% -47% -38% -29% -25% -14% -11% -5% -1% Global Equities UK Equity Income Property Global High Yield Commodities EM Bonds Strategic Bond Global Corporates Absolute Return Global Aggregate Global Treasury Sterling Gilts Past performance is not a reliable indicator of future returns. Sources: Vanguard calculations based on data from Barclays, Macrobond, and Morningstar, Inc. Notes: Global Equities are defined as the MSCI ACWI Index, UK Equity Income defined as the FTSE 350 High Yield index, Commodities defined as the S&P GSCI index, Global High Yield defined as the Barclays Global High Yield Index, EM Bonds defined as the Barclays Hard Currency Index, Property, Strategic Bond, and Absolute Return are defined as the median return from the Morningstar Database from October 2007 to 28, February 2009, Global Corporate Bonds defined as the Barclays Global Corporate Index (hedged to GBP), Global Aggregate defined as the Barclays Global Aggregate Index (hedged to GBP), Global Treasury Bonds are defined as the Barclays Global Treasury Index (hedged to GBP), and Sterling Gilts are defined as the Barclays Gilt Index. All returns are in sterling terms with income reinvested. 10
Short-term bonds in balanced portfolios; Not what you might expect Rolling 36-month volatility Median quarterly return during the worst quartile of global equity performance 2001-2014 Annual volatility (%) 14 12 10 8 6 4 2 6% 4% 2% 0% -2% -4% -6% 0-8% Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Global Agg Global Agg 1-5 50% Global Equity /50% Global Agg 50% Global Equity /50% Global 1-5YR Sep-12 Sep-13 Sep-14 Equities 1 to 3 years 3 to 5 years Aggregate Market 7 to 10 years 10+ Years Past performance is not a reliable indicator of future returns. Source: Vanguard calculations, using data from Barclays Live and Macrobond. 11
Active tends to underperform on average Percentage of active managers underperforming their benchmark, 2000 to 2014 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Equities Fixed income Global equity Surviving funds U.K. equity European equity Eurozone equity Surviving + "dead" funds U.S. equity Emerging market equity Global bonds GBP diversified bonds GBP government bonds EUR diversified bonds USD diversified bonds Past performance is not a reliable indicator of future results. Sources: Vanguard calculations, using data from Morningstar, Inc. Notes: Fund universe includes funds available for sale in the UK, filtered according to the description above, from the following Morningstar categories: UK equity flex cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Europe equity Europe OE: flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Euro zone equity flex-cap, large-cap, mid-cap, small-cap; Global flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; US equity flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Emerging markets equity emerging markets; Europe bond EUR diversified; US bond USD diversified; Global bond global un-hedged bond; UK bonds UK diversified, UK government. Performance is for periods ending on 31 December 2014. Performance is calculated relative to prospectus benchmark. Fund performance is shown in GBP terms, net of fees, gross of withholding tax, with income reinvested, based on closing NAV prices. 12
Adding passive can help reduce client risk Active portfolio Client pulls all assets Risk of losing clients Client pulls most assets Client pulls some assets Client asks questions Market return Portfolio s periodic return Adding passive Client pulls all assets Risk of losing clients Client pulls most assets Client pulls some assets Client asks questions Market return Portfolio s periodic return Source: Vanguard. 13
Why global bonds? Diversification. The global market is diversified across currency, bond type, and maturity/duration, resulting in a high quality investment-grade bond portfolio with intermediate-term duration. Intermediate-term duration. High quality intermediate-term bond portfolios tend to diversify equities well relative to both short and long-term bonds. Interest-rate risk. Given the different interest rate environments in the global bond market, some of the interest-rate risk can diversified due to the generally low correlation among government bonds yields. In other words, if yields increase in the UK, they may be flat or decreasing in other parts of the world (i.e. Eurozone and Japan). Low cost. A global bond index fund tends to be low cost, which is especially important today given low yields and expected returns in the 2 to 3% range. Costs decrease yields pound for pound and the lower your costs, the more of your yield that is preserved. Core holding. The portfolio can be used as a core holding with active satellites or as a stand alone option. 14
Appendix 15
UK market structure differs significantly in bonds too Maturity distribution Sector distribution 60% 80% 50% 70% 60% Weight in market 40% 30% 20% Weight in market 50% 40% 30% 20% 10% 10% 0% 1-3 Year 3-5 Year 5-7 Year 7-10 Year 10+ Year 0% Central Govt. Govt. Related Corporate Securitised Sterling Aggregate Global Aggregate Sources: Vanguard calculations, using data from Barclays Capital Data as of: 31 December 2014. 16
Structure of the UK market vs. global market UK is typically longer duration and (in large part due to the higher interest rate risk, and slightly higher inflation profile) typically higher yielding than the global market Yield 7 Duration 10 6 5 4 3 2 1 9 8 7 6 5 0 1999 2001 2003 2005 2007 2009 2011 4 1999 2001 2003 2005 2007 2009 2011 UK Global Sources: Vanguard calculations, using data from Barclays Capital. Past performance is not a reliable indicator of future results 17
Relative volatility and correlation both impact the hedging decision Currency correlation becomes less important as portfolio volatility falls Thus, hedging is more likely to reduce risk in fixed-income oriented portfolios Hedge Don t Hedge Note: Hypothetical illustration of the difference in volatility between a hedged and unhedged investment, with various assumptions regarding underlying portfolio volatility and currency correlations. Figure assumes 10% currency volatility. Red shading indicates hedging produces a higher volatility outcome while green shading indicates hedging lowers portfolio volatility. Expected volatility ranges for various asset allocations are hypothetical projections, based on Vanguard s capital markets outlook (Davis, et al., 2014). 18
Contact details Andrew Surrey Strategic Account Manager Direct line: 0207 753 4994 Mobile: 07712 324 237 Email: andrew.surrey@vanguard.co.uk Nick Davis Business Development Wealth/Asset Managers Direct line: 0207 753 6941 Mobile: 07885 806078 Email: nick.davis@vanguard.co.uk 19
Important information This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. This document is designed for use by, and is directed only at persons resident in the UK. The opinions expressed in this presentation are those of individual speakers and may not be representative of Vanguard Asset Management, Limited The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information on this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results. Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall. Investments in smaller companies may be more volatile than investments in well-established blue chip companies. Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds. Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority. 2015 Vanguard Asset Management, Limited. All rights reserved. VAM-2015-10-07-2964 20