World government bond markets: an Australian perspective

• 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.

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.

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.

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.

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).