The Global Bond Market: Potential for Better Risk Management

Never before was there more reason to diversify bond holdings among other countries than the present. The US government is expected to have to cover over $2 trillion of budget deficits between now and the end of 2011. Unless Congress and the President radically change their ways, the country will pile on more and more debt until the currency sinks to a worthless fiat currency, effectively creating massive unemployment and something close to a depression. The US Congressional Budget Office estimates that US debt as a percent of GDP will increase to 100% of GDP. By comparison Greece is at about 60% of GDP as this is written.

From 1940 to about 1946, the US debt as a percentage of GDP grew from about 55% to around 123%. But that was then when many American families purchased war bonds so that the debt was spread out over many holders. The average war bond cost $18.75. Today, bonds are issued in the billions of dollars and only wealthy institutions, governments, pensions funds, and other countries can afford to purchase them.

It was recently reported by Moneynews.com that foreign holdings of US Treasury securities dropped $34.2 billion in December. Alan Meltzer, an economics professor at Carnegie Mellon University, believes that the Chinese are diversifying away from US debt because they now have less faith in the ability of the US to pay its debts. If this decline in demand for US debt securities continues, the result will be higher interest rates on US debt issuances.

The challenge for the US today is complicated by the weak economy. The government is naturally reluctant to rein in spending under the Keynesian theory that every $1 of government spending multiplies in the economy. If the government did rein in spending, the economy could slide back into a recession, or best-case-scenario, a no-grow economy. Therefore, if the prospects for reduction in bond issuances in the next few years are slim, then what can financial institutions the world over be expected to do? Diversify bond holdings is the apparent answer.

Sixty percent of the world's bond supply is outside the US. Look at the indexes, the total bond market measure is about $35 trillion. The Barclays Capital Global Aggregate Bond Index was more than twice as large as the Barclays Capital US Aggregate Bond Index. If any one was worried about diversification, the Global Aggregate Bond Index represented over 12,000 issuers from over 50 countries. As of December 31, 2009, the index was as follows:

There are several aspects to this topic. Many institutions believe risk management should take priority. Return of capital is more important than return on capital, as the saying goes. With bonds, it is especially true. Bonds can be very volatile, especially in times of severe inflation. If a manager can spread bond holdings over multiple countries with multiple currencies and yields, a bond portfolio is much more diversified and accordingly, the volatility....the ups and downs of the market should be reduced. Wouldn't it be nice if a bond portfolio  moved 100% opposite of the S&P 500 stock index? In other words, for every $1 rise in the bond portfolio, the S&P 500 would decline $1. Well, there is one. Actually, it's an index....the Barclays Global Aggregate Ex-US index. It has a perfect 1.00 correlation to the S&P 500 stock index. So, if we can build a portfolio with 50% international bonds without US bonds and 50% in the S&P 500 stock index or certain stocks, we would have a very nearly perfect correlated portfolio. If the up-and-down movement is substantially reduced, we have reduced risk and this is what risk management is all about.

Another aspect to the global bond market potential to consider is the credit ratings given by the credit rating agencies. Setting aside the alleged scandalous behavior of certain US rating agencies during the US mortgage debt crisis, if we can put together a group of mutual funds that invest solely in foreign countries, we will get the diversification and risk reduction from that, but we need to be careful about ratings.

Ratings run from AAA to CCC and below. High yield bond funds have less of the AAA rated bonds and more of the bbb and below rated bonds. But at the same time we are looking at ratings, we must go back to the percentage of debt to GDP ratio. We would like to see it in the 20 to 30 range...no higher. Portugal, Ireland, Italy, Greece, and Spain are five countries which are in debt trouble as well as economic and political trouble. They have high debt to GDP ratios. Greece is around 60%. When we look at a global  bond mutual fund, we do not want to see those countries among the individual holdings.

Another aspect to the global bond market potential is the economic strength of the countries in the world. That is a key factor because the present move away from the US bond market is being driven in part by the perceived economic weakness in this country. A combination of a severe recession, a negative export vs. import picture, slow recovery, excessive government spending and a socialist leaning government all combine to accelerate the capital movement away from US bonds and towards foreign bonds, especially emerging market bonds where countries are running surpluses. Like corporations, they are profitable. The US may never see surpluses again in our lifetimes.

Asian countries that offer opportunities for global bond diversification are China, Korea, Japan, and India. These countries are engines of growth and have been for some time. Diversification among different economies is a desirable goal. Care must be taken by bond managers about China, or any other country that might be experiencing run-away growth. For example, China is currently experiencing some irrational exuberance in real estate prices. But the Chinese government is acting quickly and decisively to restrain the demand, something the US did not do very effectively in the 2006-2007 period.

The global bond market has a variety of bond asset classes. Examples include inflation-protected securities, corporates, asset-backed securities, derivatives, and high-yields. Diversification among asset classes is a desirable goal because there is a diversified set of total returns. For example, we like both domestic and foreign corporate bonds at this time because we think their yields and prices have a chance for greater stability.

Diversification among peace-loving nations can be an attractive alternative to the US bond market. This is not intended as a political statement. The fact of the matter is wars are costly. They are costly in many terms, human lives, material resources, lost opportunities for growth and prosperity, just to mention a few. More particularly, they are costly in terms of yield, prices, and debt levels of the warring country's bonds. The US has been in many of the wars over the last century, and it would not be unreasonable to say that a significant portion of the US public debt can be traced to the need to fund wars.

If you had to rate bond risks on a scale of 1 to 10, inflation would be either a 9 or a 10. There is nothing more destructive to asset values then inflation. Bonds are particularly prone to inflation risk. The main reason is the fixed interest rate at time of issuance. In an inflationary environment, investors demand a higher return to compensate for the loss in currency value. If a bond has a fixed rate of return, the price has to move lower in order to entice future investors to buy. Diversifying in the global bond market will not protect an investor from the effects of worldwide inflation. It may offer more protection if inflation rates vary among countries, allowing a bond portfolio manager to cherry-pick countries where future inflation prospects are lower than normal.

Inflation-protected securities such as TIPS provide some protection against inflation. Our portfolios have a limited allocation to a TIP mutual fund. The interest rate is very low but the appreciation in 2009 was about 13% and that's why we like the fund. We have held a short bond ETF for a time, but it is not performing as we would have expected.

In summary, the US bond market is unlikely to offer returns greater than the global bond market. It may be that the future returns from US bonds will be less than global bond returns. Capital preservation has to take priority over performance. Therefore we will diversify globally.