- Changing regime of global interest rates has brought opportunities for reassessing asset allocation. This blog is in particular looking at global fixed income allocation from Australian investors point of view.
- The newly volatile world poses challenges for institutional investors taking global fixed income exposures while optimizing balance between risk and return.
- A combination of tactical implementation, such as currency hedging, use of passive funds/ETF, curve strategy using Carry and Roll Down factor within global bond allocation would have provided yield enhancement for global government bond portfolios.
- Globally, the tail-risk caused by climate change is no longer trivial, due to both the longer duration of government bonds and increasing emission in greenhouse gas, asset managers are looking for a solution to protect their fixed income portfolio.
For diversification and yield enhancements, it has been a long prudent practice for the asset of Australian superannuation funds to have significant allocation into global fixed income market. In recent two years, we have seen global interest rates have behave remarkably differently than what it had been for the previous two decades.
Most notable, or rather unexpected, is the speed of rising interest rates in the US, has been outpacing other developed economies. If a country’s rugby performance were to have a high correlation with the pace of rising interest rates for government borrowings, we would not have missed USA in the world cup this year. US interest rates has pushed the yield to maturity of global government bond portfolio, as represented by FTSE World Government Bond Index (WGBI) in Table 1, from 1.5% back a decade ago, into 3.7% as of September 2023. Table 1 provides the level of interest rates and weight for countries in WGBI.
Table 1. WGBI Profiles
|Countries||Market Value (USD Million)||% Market Weight||Yield to Maturity||Effective Duration||World Rugby Ranking*|
|United Kingdom||1,053,138||4.37||4.55||9.56||Scotland (5), England (6), Wales (8)|
Source: FTSE Fixed Income Index, World Rugby. * World Rugby ranking is as of 18 September. ** South Africa was in WGBI from 2012 to 2020. Past performance is no guarantee of future performance. Data shown represents hypothetical, historical performance. Please see the end for important legal disclosures.
On one hand, from yield to maturity perspective, a decade ago, Australian commonwealth government bonds had 150-200 bps yield advantage over the WGBI, whereas it’s been narrowed down tremendously since 2019, and it’s now only 40 bps higher than WGBI in Sep 2023 (Chart 1). On the other hand, from FX perspective, the depreciating AUD is eroding the return for AUD investors who holds domestic assets. Chart 2 shows the AUD has depreciated 12% against EUR and 32% against USD respectively since 2013. Other than rugby, it is time to conduct a review of our investment strategy in global stage.
Chart 1. Historical yield of Australian government vs WGBI - Yield of Australian Govt. Bond Index vs WGBI
Chart 2. Historical AUD/EUR and AUD/USD FX Rates
While the table above illustrates government bonds, we understand that majority of Australian investors is benchmarked against a broader global bond index, including global credits as well as emerging countries bond markets.
Chart 3 compares WGBI and the broader global bond index including credit: World Broad Investment Grade Index (WorldBIG). It illustrates that a decade back, taking an exposure into global credit would have provided a significant yield pick-up relative to global government bonds. Given the current global government bonds provides 3.7% yield, the additional 50-60 bps pick-up from exposures into global credit only constitutes around 15% higher yield relative to what government bond portfolio can provide. Institutions should question whether additional resources for credit research, credit risk management as well as additional management fees (if using external managers) would justify the yield enhancements from credit risk exposures. We have seen investors globally are shifting their “core” global fixed income allocation into global government bonds, utilising lower cost passive funds or ETF vehicles tracking WGBI, while at the same time allocating their risk budget into more aggressive yield chaser strategy such as high-yield or even private credits.
Chart 3. Historical Yield of WGBI vs WorldBIG
In terms of diversification across local currency government bonds, we also would want to look at weight and level of interest rates across developed and emerging government bond markets. Chart 4 provides comparison between WGBI and FTSE Emerging Markets Government Bond Index (EMGBI). Similar to our earlier discussion on global credits, investors would need to ask how much exposure in emerging markets that would provide optimal yield enhancement and diversification benefits as opposed to additional risk and investment cost from exposure in emerging markets. While we are yet to see China in rugby world scene, it has become increasingly important bond markets. As a reminder, FTSE Fixed Income Index has a robust governance process of country classification, and only countries with the “gold” standard would be included in flagship WGBI. WGBI only started to include China Government Bond into WGBI from October 2021, with gradual increase of weight over 36 months. As of September 2023, China weight in WGBI at 5.89% (Table 1) is roughly still a 2/3 of its potential full weight. Other index provider may have included China earlier and reaching full inclusion, and China weight in broad index is even much higher after adding up the non-government portion of China local currency bonds. At current global interest rates regime, while ones can think of diversification benefit, China yield has been less attractive compared to US (2.47% vs 4.71% as in Table 1). Taking a balance of diversification versus expected yield, Investors may take tactical allocation approach into China, where available ETF tracking FTSE China Government Bond Index will serve well as lower cost vehicle for this purpose.
Chart 4. Historical Yield of WGBI vs EMGBI
We can look at few items to consider in global fixed income allocation.
- Optimizing global government bonds using Carry and Roll Down factor. This strategy allows investors to optimize yield without having to take exposure into credit risk. This strategy will maximize expected returns by allocating weight into section of the curve that provides highest expected return from carry and roll down factor, while ensuring duration is kept same as base index. We have implemented this strategy into FTSE Carry and Roll Down (CaRD) WGBI, which has shown outperformance of 50 bps annualized over standard WGBI in the past 15 years.
- 0+ Index strategies. Standard bond indexes impose a rule that excludes bond less than one-year maturity. We recognize that this rule forces index followers to sell bonds at cost, and has published 0+ years Index series in order to avoid the problem. Moreover, for investors who has a view for the short-end of the curve, in particular given the inverse yield curve in US yield curve, using 0+ version of WGBI and WorldBIG can provide yield advantage.
- Tactical currency hedging. Our colleagues have recently written an analysis (A currency hedge that didn’t need to be trimmed) that taking a currency hedged version of generally known lower yielding Japanese government bonds, would have given a higher yield. While they look at the opportunity from the view of US investors, we have done similar analysis that Australian investors will also benefit from similar strategy.
- Sustainable Investment. Global asset owners have a rising awareness of the threat ignoring ESG integration into managing fixed income portfolio, this has driven the demand of Sustainable investment fixed income (SIFI) products. FTSE Climate Risk-Adjusted WGBI and FTSE ESG WGBI are designed to fulfil this trendy market need, they both provide comparable return and acceptable tracking errors versus WGBI. In addition, they don’t necessary underperform Australian domestic bond market, when we make comparison with FTSE Australian Broad Investment-Grade Bond Index (AusBIG).
Chart 5. Return (AUD) of WGBI vs Climate Risk-Adjusted WGBI, ESG WGBI and AusBIG
© 2023 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) FTSE Fixed Income Europe Limited (“FTSE FI Europe”), (5) FTSE Fixed Income LLC (“FTSE FI”), (6) The Yield Book Inc (“YB”) and (7) Beyond Ratings S.A.S. (“BR”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “FTSE4Good®”, “ICB®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this document should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset or whether such investment creates any legal or compliance risks for the investor. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset nor confirmation that any particular investor may lawfully buy, sell or hold the asset or an index containing the asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This document may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB, BR and/or their respective licensors.