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Rising US rates – which now look as though they will rise once more at the end of this month – lousy total returns and a weakening dollar have left the smart bond fund money looking abroad.
US bond investors are facing a conundrum. In spite of hosting one of the developed markets’ most attractive interest rates, US bonds have been losing investors money as rising yields have chewed away at total returns.
According to the MSCI World Sovereign Debt Index, US sovereigns fell 1.6 per cent during the first four months of the year. Except for Japan and New Zealand, every other developed sovereign market was up in dollar terms. That is because of two factors: foreign interest rates are generally not rising as fast as those in the US; and local currency is appreciating against the greenback.
These factors are driving significant outperformance by many global bond funds against their domestic counterparts. And, looking ahead, the near-term prospects remain favourable. According to Bill Gross, Pimco’s much venerated bond manager: “The process of rebalancing the current global disequilibrium most likely means dollar-based assets and the dollar itself should continue underperforming global alternatives.”
Morningstar’s data bear out the current trends. Over the past three years, up to May 29, US-based global bond funds are up an annualised average of 4.07 per cent, outperforming domestic intermediate-term bond funds by 225 basis points. Over the past five years the spread is nearly 300 basis points, with the average
global bond fund returning 7.61 per cent.
The top-performing global bond funds are generating the kind of numbers that would make even equity managers envious. Let’s take a look at how they did it.
Oppenheimer International Bond Fund, with $4.94bn in assets, has generated three-year annualised returns of 10.51 per cent and five-year returns of 14.04 per cent.
Portfolio manager Arthur Steinmetz did this, in part, by overweighting emerging markets: 35 per cent against his benchmark weight of 20 per cent. Even after the May meltdown, Mr Steinmetz’s one-year return is 4.78 per cent, 400 basis points above the world bond fund average.
He also focused on improving credit plays. One-third of his portfolio is in junk-rated bonds that pay high yields, with the prospect of capital appreciation as issuers’ credit quality improves. Mr Steinmetz gains substantial ballast with one-third of his assets locked into US high-grade debt, which helps the portfolio sustain an overall credit rating of AA.
Templeton Global Bond has done almost as well, with three-year annualised returns of 7.98 per cent and five-year annualised returns of 13.43 per cent. Co-manager Michael Hasenstab has a large exposure to the Asia-Pacific markets with 40 per cent of the fund’s $2.31bn assets parked in Korea, Thailand, Singapore, Malaysia, Indonesia, as well as Australia and New Zealand.
Despite the volatility of the last month, Mr Hasenstab believes global structural imbalances have not changed. “They are squarely in favour of many Asian and European currencies, while many emerging market fundamentals remain strong”.
Where Mr Hasenstab truly deviates from the crowd is in his US exposure. Where his benchmark, the Citigroup World Government Bond Index, assigns a 21 per cent weighting to US debt, Mr Hasenstab has none. That is a real gamble, especially if US rates peak any time soon.
But he thinks currency is the trump card. “Being short the dollar offers the best opportunities,” he explains.
David Tice’s Prudent Global Income Fund has 71 per cent of the $363m fund in “AA”-rated sovereigns, and keeps 20 per cent in ultra-short US Treasuries for ballast and liquidity. But he spices things up with gold. He held a 13 per cent position – via Canadian mining stocks – as the metal surpassed the $700 mark in early May. The reason: “Gold has a low correlation with currencies,” Mr Tice explains, “offering stability and value, especially when the dollar is volatile.”
Mr Tice has certainly been helped by gold’s 150 per cent rise since he started the fund in 2000. This has lifted performance, especially over the past year, when the fund rose 10.87 per cent. Over the past three years, annualised returns were 5.66 per cent and five-year returns climbed to 11.52 per cent.
Loomis Sayles Global Bond Fund is up 4.92 per cent per year over the past three years and averaging 11.29 per cent gains over each of the last five years. Fund manager Kenneth Buntrock uses the Lehman Global Aggregate Bond Index as a benchmark, with about two-thirds in sovereigns, 15 per cent in corporates, and nearly 20 per cent in securitisations.
While Mr Buntrock can hold up to 20 per cent of his assets in junk bonds, this segment of the fund peaked in March 2001 at 16.9 per cent and currently stands at 9.5 per cent. “Compressed spreads are making it more challenging to justify the risk-return scenario for these securities,” he explains.