A constant topic of conversation in the financial media in recent years has been the degree to which central bank intervention across the globe has suppressed volatility in the markets and has caused global bond yields to fall to historically low levels. Some market veterans with a long-term perspective shake their heads in disbelief at current levels, warning others like a modern-day Cassandra, that bond investors will be in for a world of hurt once yields begin to rise.
On the other hand, you have those in what we’ll call the “Chuck Prince Crowd” who believe that “as long as the music is playing, you've got to get up and dance.” Whichever end of that continuum you might find yourself closer to, the fact remains that bond investors are forced to be “price-takers” as a result of price-insensitive central banks crowding out fundamental investors in the fixed income markets.
What we will do in this Insights Blog post is take a look at a few characteristics of the Citi World Government Bond Index (WGBI) and share our thinking on whether a dedicated allocation to WGBI-benchmarked funds is compelling at this point.
In the chart below we show the historical yields of Citi WGBI Index as well as the ex-US WGBI index. As you can see, index yields have been in an unmistakable downward trend since the credit crisis, driven lower by ballooning central bank balance sheets, global growth fears and most recently, “Brexit” concerns. At the end of June, the yield on the WGBI was about 0.59 percent, as JGB and Bund yields (together representing about 30 percent of the WGBI) plunged into negative territory, closing June at -0.22 and -0.15 percent, respectively. Taking a look at WGBI yields with U.S. Treasuries removed (WGBI ex-U.S.), reveals that the yield on offer across the rest of the constituent countries comes in at an even more paltry 0.34 percent.
A deeper dive into global yields further highlights the perceived lack of value. While we mentioned the unprecedented dive into negative territory for German and Japanese 10-year yields, even Italy, with a weight of 7.5 percent within the index, now trades at a lower yield than the U.S. 10-year Treasury. Recall that Italian, along with other “peripheral European” government bond yields, spiked higher during the 2011-12 European banking crisis, before ECB President Mario Draghi issued his famous “Do whatever it takes” proclamation in July of 2012.
Given the continued turmoil in the European Union and other global concerns, U.S. dollar-based investors (and those with liabilities denominated in dollars) must question whether appropriate compensation is being paid for the interest rate and currency risk undertaken by an investment program benchmarked to the WGBI.
An additional concern we have about the WGBI is the trend in the index’s duration. All other things equal, the lower the coupon rate on a bond the longer the duration. What we can see from the chart below is that the unmistakable trend in duration of the WGBI is higher, and most recently it was approaching eight years.
For U.S. dollar based investors who are familiar with the Barclays U.S. Aggregate Bond Index, duration has also crept higher, but at a more measured pace. To invest in a program focused on this index, you are benchmarking your risk/reward considerations in part on acceptance of interest rate sensitivity of approximately 5.5 years, significantly lower than the duration level of the WGBI.
One further consideration. While the WGBI enjoyed a strong return of 11.3 percent for the fiscal year ending June 30, its longer term performance has lagged that of the Barclays U.S. Aggregate Index, as shown in the chart below which compares the 5-year cumulative total returns of the two indices. This may be a good time to jump off the WGBI train after a good run.
So what are we suggesting? While U.S. dollar-based investors have historically looked for a diversification benefit from WGBI-benchmarked investment programs, at this stage in the global rates cycle, it is a challenging proposition to consider investing in a WGBI-benchmarked investment program given the paltry yields on offer, the increased interest rate sensitivity and the foreign exchange risk that is undertaken as a result of allocating to this type of program. We would suggest that these issues are weighed carefully on a go-forward basis, given that we believe it is possible to find more compelling risk/reward opportunities in U.S. markets, as well as select global markets that are not well represented by the WGBI.