By Robert Vanden Assem
The post-crisis years have seen two key developments in the fixed-income markets. One is the shift in focus from government bonds, whose ratings have lost their luster thanks to huge-scale central bank intervention round the world, toward investment grade credit. The other is the further shift of many European investors and investment managers from domestic credits to a globally diversified credit selection.
Superficially, this looks to be a sound strategy, offering both diversification and enhanced returns. After all, the broader and deeper the “credit universe”, the greater the opportunity set, thus the larger the stage on which investors can act out their strategies. While such a strategy certainly offers diversification, there are big questions over whether this translates into superior risk-adjusted performance.
Take for instance a key indicator of the success of any investment manager at converting risk to returns, known as ‘the information ratio’, which divides the strategy’s excess return versus its benchmark by the volatility of that excess return. Our analysis shows that, contrary to the supposed superiority of global strategies, their US dollar equivalents outperformed their global rivals on a risk adjusted basis across five and 10-year periods.
Counter-intuitive though it may seem – and it certainly runs counter to the notion that “going global” is the key to superior returns – it would seem that expanding the investable universe, the “opportunity set”, may actually detract from the likelihood of generating such returns. In understanding why this may be the case, the best place to start may be in correcting a common misconception, that the global credit universe is vastly more broad than the dollar-denominated one. Although the global credit market is larger in terms of market value and number of securities, the gap between the global and dollar-denominated credit markets is a lot smaller than many people think.
In part, this is because many of the most liquid international names are very likely to issue dollar-denominated bonds. In fact, non-US issuers represent nearly 30% of the dollar-denominated credit market today. Furthermore, expectations that the Federal Reserve will continue to peel away from other central banks and pursue the “normalisation” of monetary policy support higher yields for dollar-denominated asset across the world. That explains the benefits of strategies investing in the dollar-denominated credit market, but what accounts for the under-performance by managers enacting global strategies?
This would have to start with the hazards confronting such a manager, including exposure to foreign-exchange and interest-rate risk. Whereas a dollar-denominated credit manager can focus on generating excess returns primarily through bottom-up credit selection, global credit managers must make currency decisions that have, over time, added more volatility than returns to portfolios, and the divergence of US monetary policy from the global trend that began with the tapering of quantitative easing in 2014, has increased volatility in the foreign exchange and rates markets.
Global credit managers have become further challenged by the trend of central banks around the world to adopt extraordinary stimulus measures to combat low growth and inflation. Not only have their stimulus policies prompted a long-running search for yield, but they have themselves became active players in the global credit market, with the Bank of Japan, European Central Bank and, more recently, the Bank of England all purchasing corporate bonds in their domestic markets.
By contrast, global credit exposure through dollar-denominated credits bypasses these challenges. Of course, investors still need to be cognoscente of the risks, the biggest, in our view, being a Fed that may seek to push ahead with rate rises in the face of an uncertain economic climate, domestic and overseas. However, corporate balance sheets remain strong, and steady if unspectacular economic growth seems set to continue. Both factors which should benefit investors in dollar-denominated credits.
Investors can also be encouraged that, despite the longevity of the current US credit cycle, there are few if any signs of the “bubble” that may, in more usual times, have been expected to appear by now. This time round, there are few signs of the sort of over-extension of credit that could lead to a recession and given the historically low cost of financing debt we don’t anticipate that happening.
This takes us to our final reason for European investors considering dollar-denominated global credit, America’s economy stands out among the advanced nations as having the best prospects for both growth and for inflation, particularly given the fiscal stimulus that PresidenteElect Trump and the Republican controlled Congress are likely to deliver.
To sum up, we believe this is an asset class offering the best of both worlds: exposure to higher-yielding global investment-grade credits with few of the risks of a traditional global credit strategy.
Robert Vanden Assem is managing director, head of developed markets investment grade fixed income at PineBridge Investments
