Seizing the moment: is now the time to invest in global sovereign bonds?
Vikram Aggarwal highlights the opportunities available within global sovereign bonds against the backdrop of falling interest rates and increased volatility.
Investing in global sovereign bonds has been challenging for investors as the fixed income landscape has undergone a seismic shift in recent years, offering investors both unprecedented opportunities and heightened risks. As the Federal Reserve initiates a rate-cutting cycle, the asset class has reemerged as a potentially compelling investment opportunity for active investors.
Understanding Global Sovereign bonds
Global sovereign bonds are debt securities issued by governments worldwide. These bonds represent a loan from the investor to the government, with the promise of repayment of the principal along with periodic interest payments. They are generally considered to be among the safest investments, as governments are less likely to default on their debts compared to corporations. Of course, the level of risk and potential for returns varies greatly between countries, with developed markets such as the US, UK and European government debt offering lower yields, but less chance of defaults compared to countries in emerging markets such as Mexico, Argentina and Brazil. We believe that there is a role for a more active and unconstrained government bond strategy in this environment where correlations are not so consistent and not negative versus other asset classes.
Good times back for bonds
The landscape within fixed income investing has shifted dramatically in recent years, presenting investors with unique opportunities and challenges. As the Federal Reserve embarks on a path of interest rate cuts, the allure of global sovereign bonds has resurfaced. This asset class, often overlooked in favour of equities, offers a blend of income generation, diversification, and potential capital appreciation.
Government bonds have struggled recently, as the era of ultra-low interest rates meant that investors looked elsewhere to find returns. Over the past few years, as interest rates have been raised and monetary policy tightened, we have entered a new environment for the asset class, defined by elevated volatility and a dispersion in returns amongst global sovereigns. This is something we expect to stay and as such could makes it an asset class for active investors attempting to beat the index. We believe that there will be more desynchronised economic cycles as countries are at different points on the growth/inflation matrix and different central banks take different measures. For example, the Brazilian central bank has in fact been cutting rates much earlier than developed markets and has just hiked rates. This means that there are more opportunities for idiosyncratic returns, capturing individual country ‘alpha, and potential for outperformance for active managers.
After a decade of ultra-low interest rates, yields on government bonds have returned to relatively attractive levels. For example, the chart below shows how yields (as tracked by the Bloomberg Government Bond Index) have returned to the top quartile after falling significantly over the past 10 years. Of course, it’s important to remember that quoted yields are not a guide or guarantee of the level of returns, but it highlights how the asset class has returned to favour amongst investors.
Bloomberg Global Aggregate Treasuries Index – Yield to Maturity – 2004-2024
Source: Bloomberg, as at 30.04.24
The chart below shows the historic performance of government bonds following the start of rate cutting cycles. There is only one instance of three years after the first rate cut where we have seen negative total returns in US Treasuries. The red line shows the average return, which is around 10% a year, and about 30% cumulatively over three years. Therefore, from a capital appreciation perspective, history shows that we’re entering a productive environment for government bond investing.
US Treasuries: total return after first rate cut from the Fed
Source: Bloomberg, as at 30.04.24
The importance of global diversification within sovereign bonds
Global sovereign bonds can play a crucial role in diversifying a multi-asset investment portfolio. Historically, they have exhibited negative correlations with equities, meaning they tend to move in different directions, so when equities go up, bonds fall and vice versa. However, over the past few years, the strength of this correlation has weakened, and even turned positive, such as in 2022, when bonds and equities moved in unison. This put off many investors who understandably looked to the role of global sovereign bonds to diversify their portfolios. This has meant that in order to achieve true diversification we have had to look into emerging market sovereign debt, sovereign credit and currencies in order to structure a portfolio that delivers the traditional role as a hedge against riskier asset classes.
We believe that emerging market sovereign debt is an attractive space to find compelling individual country investment opportunities, benefitting a diversified portfolio. Another point to highlight is the fact that emerging markets are becoming a larger part of global government bond indices. For example, over the last 10 years EM has moved from representing 4% of the global government bond index to now representing 15%. Looking ahead, over the next 10 years, one would expect that to move higher as countries such as South Korea are added to global government bond indices.
Therefore, the current market conditions, characterised by declining interest rates and increased volatility, may present an opportune time for investors to consider global sovereign bonds. By carefully considering the advantages of active management and the diversification benefits of global sovereign bonds, investors can position themselves for long-term success.
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Past performance is no guide to future returns.