This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.
For years now, investors have prepped for higher interest rates here in the U.S. There were various tactics used to diversify away some of this risk, including introducing non-U.S. bond ETFs into a portfolio.
This has been a fruitful trade over the past few years, as the continued phenomenon of central bank intervention abroad has pushed rates in other countries into negative territory. While the ride down to this negative interest- rate policy (NIRP) has produced some nice positive price action, it would seem NIRP is not sustainable, and that eventually there will be a ride back up (and hence a reversal in the price positivity).
So if the rise back to positive interest rates in these countries is forthcoming, is the non-U.S. bond trade still worth keeping on in the meantime? If not, what are some alternatives?
As stated above, non-U.S. fixed income has been a strong trade recently. The chart below shows the differential between the underlying index for the iShares Core International Aggregate Bond (IAGG) and the iShares Core U.S. Aggregate Bond ETF (AGG | A-98).
After trailing decently during the six-year period from 2005-2011, the international index has performed strongly since, outperforming the U.S. index by 237 basis points per year (5.13% versus 2.76%) since the end of 2011 through April.
The question that may arise now is: Is that outperformance sustainable? The market has already seen some stabilization over the past year or so, which is evidenced by a flattening out in the differential in the chart above. Taking a step back, we can look at the underlying interest-rate action during this period.
This first chart shows the change in the U.S. curve versus the benchmark European and Japanese sovereign curves from the end of 2005 to the end of 2011.
During this period, there was a dramatic shift lower in U.S. rates. This compares to a moderate move lower in European rates and a rather unchanged Japanese curve. It should not be a surprise that the U.S. index outperformed during this period given the price appreciation it experienced from the rate move.
Conversely, here is the same chart from the end of 2011 through the end of April 2016:
Over this period, European rates continued to decline as did Japanese rates (particularly on the long end), while U.S. rates increased across most the curve. The corresponding price appreciation led to the relative performance in the non-U.S. index over the period.
So where does that leave us now? As I mentioned above, central bank policy abroad has pushed rates to extremely low and/or negative rates. Here are the three same curves as of the end of April:
As you can see, Japanese and European rates are significantly lower than in the U.S. In addition, most of both the European and Japanese curves are negative from 10 years and in.
Non-US Rates More Likely To Rise
Does this mean the U.S. will follow suit, and rates will shift lower? That would seem doubtful now, with the Fed’s initiative to raise rates. It seems a more likely scenario would be that non-U.S. rates would shift back up toward the U.S. However, given continued central bank intervention, the timing of that move higher is a bit of an unknown.
A third scenario would be that both curves just linger where they currently reside. If that were the case, the non-U.S. bonds would have almost no yield given where the curve resides, while the U.S. would still generate at least some positive yield return. It would seem these scenarios would not favor non-U.S. sovereigns at this point.
For someone wanting to stay outside the U.S., it would seem the natural progression would be to step lower in quality. However, on the international side of things, moving from sovereign exposure to more pure investment-grade corporate exposure does not really give much of a yield boost.
The underlying index for the SPDR Barclays International Corporate Bond ETF (IBND | C-99) at the end of April was also 1%. Because the makeup of the international corporate market is a much shorter duration than sovereigns (about 1.6 years shorter, all coming from the long end), by switching from aggregate to corporate exposure, the trade-off is just long-end curve exposure to spread exposure.
Currency Risk Part Of Equation
Additionally, because there are not currently currency-hedged international investment-grade corporate ETFs available, by making a switch, an investor would also be adding in currency risk. While at times this may be advantageous and at times not, at a minimum it would add volatility into the equation.
Investment-grade corporate spreads abroad are trading decently tighter than here in the U.S. Using index data, U.S. investment-grade corporates currently have about 0.50% additional spread versus non-U.S. investment-grade corporates (1.50% vs 1%). This relationship has flipped since the end of 2011, when it was 0.50% in favor of non-U.S. (+2.8% vs +2.3%). This adds an additional layer of reversion risk in international investment grades if this relationship were to flip back.
Additionally, similar to the U.S. versus non-U.S. sovereign argument, investment-grade corporates abroad would have also benefited from the same underlying curve moves and price appreciation differential since 2011. Therefore, this adds an additional layer of reversion risk if we see curve moves as described previously.
In conclusion, the addition of non-U.S. bonds into a portfolio would have proved fruitful over the past few years. However, because of changing relationships and continued central bank intervention, the previously strong case for these non-U.S. bonds may be waning.
The above constitutes the personal, professional opinion of Clayton Fresk, CFA, and does not necessarily reflect the views of Stadion Money Management LLC. References to specific securities or market indexes are not intended as specific investment advice. At the time of writing, Stadion did not own any of the securities referenced. Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com.