Assessing International Bonds in an Ultra-Low-Rate Era

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by Peter Wilson, Global Fixed Income Strategist

Key takeaways

• International bonds in diversified U.S.-dollar-based portfolios have the potential to provide income comparable to that of domestic assets, with diversification benefits intended to compensate for currency volatility.
• Currency swings have remained very volatile over time. Yet, the income and diversification benefits of international bonds—particularly from developed markets (DM)—are much less significant now, in the current low-rate era, than they were some years ago.

What it may mean for investors

• We expect interest rates overseas to remain low for some time, so income returns should also remain subdued (particularly in DMs). The lower rates go, the greater the capital-loss likelihood (and the smaller the income cushion against losses should rates eventually rise).
• We expect currencies to remain unpredictable, but DM bond income and capital gains do not offset currency volatility as much as they have historically. Thus, we are unfavorable on developed market bonds ex-U.S. and prefer to seek income via emerging market sovereign debt, where we remain neutral.

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In July, eurozone sovereign bond yields renewed historic lows, with 10-year German bund yields moving below -0.40% and 10-year French government bonds reaching negative territory for the first time. As European Central Bank (ECB) easing continued, the outstanding amount of negative-yielding bonds reached $13.4 trillion on July 3—and composed approximately 24.5% of the Bloomberg Barclays Global Aggregate Bond Index. Yet, demand shows little signs of flagging. A reopening of Austria’s 100-year sovereign bond, originally issued in 2017, came at a yield of just 1.17% and was almost five times oversubscribed. The market expects cuts in the ECB’s deposit rate (currently -0.40%) and a possible resumption of central-bank bond purchases as early as this autumn. The news that outgoing ECB president Draghi will likely be replaced by International Monetary Fund (IMF) head Christine Lagarde has done nothing to cool the dovish expectations. Therefore, it is quite possible that, even from current ultra-low levels, international sovereign yields could grind lower still.

The theory

Nonetheless, looking at the bigger picture, we are not convinced that unhedged non-dollar DM bonds are earning their place in diversified U.S.-dollar-based portfolios. In traditional asset allocation theory, the benefit of adding sovereign bonds outside the base currency came principally from risk-reduction via diversification. Currency movement was an additional source of return—both positive and negative—and this added risk (volatility of returns would be higher). But over time, currency gains and losses were considered to cancel each other out; income returns should be comparable to those of domestic bonds; and low correlation should lower risk in the broader diversified portfolio.¹

History of international DM bond returns

The following analysis of returns suggests that, while this may have been true in the last century, it is likely to be less true today. Chart 1 shows the rolling 12-month returns for the non-U.S. sovereign bond index (J.P. Morgan Government Bond Index (GBI) Global, ex-U.S.) from 1986 to today, split into three key components—interest return, principal return, and currency return.² Interest return (shown in the blue area, essentially coupon income) was around 8-9% in the late 1980s and early 1990s—but it has since been falling gradually to the current levels below 2%. The sharper yield declines in the late 1990s and early this century meant that, on average, capital gains were more likely than capital losses. As a result, principal return (the orange section) was positive, on balance. As yields have edged lower in the current period (since the 2008-2009 financial crisis), this remains the case today, albeit to a smaller extent. Chart 1 also shows that currency gains and losses are often the largest component of return. Although the amplitude of the swings has fallen from the 1980s, currency moves still contribute most to the overall volatility of international (DM) bond returns.

Chart 1. International DM bond returns continue to grind lower

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Sources: JP Morgan, Wells Fargo Investment Institute, July 2, 2019. Latest data as of June 30, 2019. Returns are calculated from the JP Morgan Government Bond Index (GBI) Global ex-U.S., an index of major developed bond markets outside of the U.S. Chart data begins in 1986 as that is the year in which this index began to track data. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Table 1 may make the picture clearer. Looking at the average 12-month return over the past four 10-year periods, we can see that total DM bond returns have fallen significantly. Of course, this is mainly due to the drop in interest return, or bond income, and it is worth noting that these returns would be even lower if falling interest rates had not created capital gains and boosted principal return.

Table 1. Decomposition of international DM bond returns

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Sources: JP Morgan, Wells Fargo Investment Institute. Returns shown are those of the J.P. Morgan Government Bond Index (GBI) Global, ex-U.S. (an index of developed bond markets outside of the U.S.). Table shows latest data available, and data is as of June 30, 2019. USD = U.S. dollar. Table data begins in 1986 as that is the year in which this index began to track data. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Market implications

The message we draw from the table and chart is this. First, international interest rates may stay low for some time yet, so overall DM bond returns will likely remain very low. However, over time, the lower the level to which DM bond yields decline, the more likely it is that the following period will see capital losses, should those yields eventually rise. Minuscule coupons on lower-duration bonds means that the “cushion” of income against these capital losses is negligible. (A good illustration of this is the 6-point fall in price that greeted the announcement of the reopening of Austria’s 2.1% 100-year issue on June 26—the equivalent of 3 years’ worth of coupon income.) Second, while coupons were substantial enough in the past to offer comparable income to U.S. fixed-income assets and to provide a counterweight to often-unavoidable currency volatility, this is far less true today—and it likely will be less so going forward. For these reasons, we maintain an unfavorable rating on DM bonds ex-U.S. and prefer to seek income via emerging market sovereign debt, an asset class on which we remain neutral.

EQUITIES

by Audrey Kaplan, Head of Global Equity Strategy; Scott Wren, Senior Global Equity Strategist

Second-quarter earnings—our growth estimates

This week, the second-quarter earnings reporting season will begin in earnest. The next three weeks will feature an avalanche of corporate results and forward outlooks. Given the poor earnings-growth comparisons relative to the year-ago period that we and the “Street” expect, the focus will be on what companies say about their second-half and 2020 prospects. The table below displays our second-quarter growth expectations for the 11 sectors in the S&P 500 Index. It is worth mentioning that, as we were last quarter, we are a touch more optimistic than consensus expectations, which call for a 2% to 3% earnings decrease. Our analysis suggests that second-quarter earnings will come in essentially flat (-0.1%). But we would not be surprised to see the index eke out a slight earnings increase over the prior-year period.
What’s behind the poor comparisons? The pressure on earnings is coming from several areas: (1) lower oil prices, (2) a stronger U.S. dollar (which can negatively impact non-U.S. revenues), and (3) supply chain disruption that is pressuring margins, especially for the largest global Information Technology and Industrials companies. This is causing an earnings headwind, especially for the largest manufacturers. If we removed the 8-10 companies from the S&P 500 Index with the largest negative impact from supply chain disruption, our analysis suggests we could forecast a second-quarter earnings growth rate closer to 5% (versus our current flat growth outlook).

Key takeaways

• We expect essentially flat second-quarter earnings growth for the S&P 500 Index.
• Supply chain disruption from U.S.-China trade tensions, lower oil prices, and a stronger dollar are headwinds that are likely to challenge second-quarter earnings results.

Wells Fargo Investment Institute second-quarter earnings growth estimates

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Source: Wells Fargo Investment Institute, July 10, 2019. Table shows Wells Fargo Investment Institute estimates for year-over-year second quarter 2019 earnings per share growth for the S&P 500 Index and its 11 sectors. Estimates are based on certain assumptions and on views of market and economic conditions which are subject to change.

FIXED INCOME

by Luis Alvarado, Investment Strategy Analyst

Awaiting a Fed rate cut?

Market participants have been expecting the Federal Reserve (Fed) to cut the federal funds target rate for several weeks now. They view this cut as an important market counterweight to the disruptions caused by slowing economic growth and trade tensions. As of last week, the fed funds futures market was pricing in two or more Fed rate cuts between now and year-end—with a 100% probability that one cut will occur at the Fed’s next meeting on July 31, 2019. Yet, we believe that the Fed will remain cautious and heavily dependent on the economic data as it continues to evaluate recent risks such as the global slowdown and trade disputes. We also believe that the Fed will cut rates only once between now and year-end.

U.S. Treasury yields remain volatile, and they have been falling since the last Fed meeting on June 19. Looking at recent history, there have been two occasions (in 1995 and 1998) when the Fed decided to cut rates preemptively. On both of those occasions, fixed-income returns remained positive and spreads over Treasury yields remained relatively flat. Additionally, as the Fed cut rates in 1998, it allowed the yield curve to move out of inversion territory, helping to prevent a recession—and prolonging the recovery.

Key takeaways

• Investors have been awaiting a Fed rate cut as a counterweight to a slowdown.
• Historically, fixed-income assets have tended to gain after a preemptive Fed rate cut.

A Fed rate cut may help to prolong the U.S. economic recovery

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Sources: FactSet and Wells Fargo Investment Institute, July 9, 2019. Daily data: January 1989-July 2019. 100 basis points equals 1%. Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

REAL ASSETS

by John LaForge, Head of Real Asset Strategy

“A nation that forgets its past has no future.” –Winston Churchill

Mr. President—Please don’t forget why we ended the gold standard

President Trump has had limited success getting his Fed nominations approved. The consensus on his latest two nominees, though, seems to be that they will be confirmed. One of them, Judy Shelton, we consider to be a surprising choice for a pro-growth president. Ms. Shelton has the rare view that the U.S. should return to the gold standard—a restrictive monetary system, last seen during the Great Depression in the 1930s. In our view, using the gold standard today (as it was used back then) could crush the U.S. economy.

The gold standard of the 1930s effectively tied a country’s credit creation to how much gold it owned. No gold = no growth. In the U.S., by law, every $100 in Fed notes had to be backed by at least $40 in gold. The 40% level was used to contain inflation—keeping the government from printing too much currency.

President Roosevelt nixed the gold standard in 1933, because it was making the Great Depression worse. The gold standard did help to contain inflation, but it had the unfortunate side-effect of making the tough times tougher, by fueling deflation. Country leaders without gold, looking to put their citizens back to work, couldn’t. No gold = no currency creation = no economic growth. The blue line in the chart represents commodity prices from 1800 to today. The shaded areas represent periods of commodity price deflation. Notice that commodity price deflation went deeper, and lasted longer, while the U.S. was on the gold standard (prior to 1933). Mr. President—please don’t forget why we nixed the gold standard.

Key takeaways

• History shows that the gold standard harmed U.S. growth and made the tough times tougher—a fact that we believe is important to remember.

Commodity bear market super-cycle

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Sources: Bloomberg, Prices by G.F. Warren and F.A. Pearson, Bureau of Labor Statistics (BLS), Bureau of Economic Research (NBER), Wells Fargo Investment Institute. Monthly data: January 31, 1800 – June 30, 2019. Past performance is no guarantee of future results. Please see the end of the report for the definition of the commodity composite.

ALTERNATIVE INVESTMENTS

by Justin Lenarcic, Global Alternative Investment Strategist

Deteriorating covenants could benefit Long/Short Credit

Despite the widely anticipated dovish tilt by the Fed at its July meeting, we continue to see a robust environment for alternative investment strategies that have the potential to capitalize on deteriorating global credit market fundamentals. Accommodative U.S. monetary policy may postpone the default cycle, as the “search for yield” could allow weaker issuers to amend and extend their debt—suppressing stress and distress ratios somewhat longer. However, we still see a strong environment for trading-oriented credit strategies, such as Long/Short Credit.

Even though Standard & Poor’s year-to-date downgrade to upgrade ratio already was 2.4:1 through early July, we might see an acceleration of that ratio as credit-rating agencies factor in the growing deterioration in covenant quality (see chart below).³ So far this year, nearly 80% of new issue high-yield corporate bonds have the weakest loan covenant score (according to Moody’s). This percentage is more than double the historical average.

The potential ramifications of a surge in high-yield credit downgrades would be wider spreads over Treasury security yields and higher volatility. This could present a very attractive opportunity for managers skilled at both long and short credit selection.

Key takeaways

• The quality of high-yield corporate debt covenants continues to deteriorate, posing a growing risk to investors.
• Ratings agencies have identified this deterioration, and they could begin to downgrade issues, leading to opportunities for Long/Short Credit strategy managers.

Deterioration in high-yield bond covenant scores

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Sources: Moody’s Investor Services, Marathon Asset Management, July 11, 2019. Data as of June 2019. Note: Moody’s covenant quality scores enable investors to rank covenant quality. The scores are presented on a five-point scale, with CQ-1 representing the most protective covenant packages, and CQ-5 reflecting the weakest covenants. The scores are applied to substantially all new issue high-yield corporate bonds in the U.S., Europe, Canada, Latin America and Asia.

¹ Correlation measures how two asset classes or investments move in relation to each other.
² Data for this index is available starting in the year 1986.

³ Sources: Z Capital Group, Standard & Poor’s, July 8, 2019.