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The World Cup of Fixed Income

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Much of the world’s attention is currently focused on the thrilling 2018 World Cup of soccer. In the spirit of some midsummer fun, it’s also a great opportunity to take an entertaining (but educational!) look at the global fixed income environment.

We present the inaugural edition of Treasury Partners’ World Cup of Fixed Income – the contest arguably no nation wants to win. Here’s how it works:

  • The participating nations are the world’s 32 largest economies (as measured by the International Monetary Fund’s 2018 nominal GDP rankings)
  • We took recent 2, 5, and 10-year sovereign bond yields for these countries and set up a separate “tournament” bracket for each maturity range
    • Where possible, we chose the yields on local currency bonds as opposed to dollar-denominated bonds (for example, Argentina issues 5 year debt paid in either Argentine pesos or American dollars, and we picked the current rate on bonds backed by Argentine pesos). If only dollar-denominated debt is available for that maturity, we used that rate and marked the country with an asterisk
    • Not every nation issues sovereign debt in each maturity – for example, Argentina doesn’t have any outstanding 2 or 10-year bonds. In these cases, we’ve marked the rate as “N/A” and treated it as a “forfeit”
  • Each bracket is based on head-to-head, single-elimination “matches” between participants, with the country with the higher yield “winning” and advancing to the next round and a subsequent match with another winner. Countries with higher rates advance further into the bracket, and the ultimate winner is the nation with the highest yield for that maturity.

First up is the Tournament of 2-Year Rates:

Source: FactSet, Treasury Partners data as of 6/20/18

Mimicking soccer, the “championship” features a marquee matchup of Brazil vs. Mexico, with Brazil’s powerhouse 8.69% annual yield handily topping Mexico’s 7.69%. Looking further down the results, it’s a thin class of “contenders,” with a large drop-off from the 3rd-highest rate (Russia’s 7.06%) to the 4th-highest (the United Arab Emirates’ 3.51%).

Let’s move on to the Tournament of 5-Year Rates:

Source: FactSet, Treasury Partners data as of 6/20/18

It’s a cakewalk for Argentina, as its stunning 22.28% annual yield more than doubles the rate of the next highest contender (Brazil’s 10.69%). India (7.94%), Mexico (7.82%), and Indonesia (6.90%) also put in strong showings. Just as in the 2-Year Tournament, the other end of the spectrum is dominated by European nations, most of which feature completely uncompetitive negative yields.

Lastly, here’s the Tournament of 10-Year Rates:

Source: FactSet, Treasury Partners data as of 6/20/18

Brazil reclaims the mantle with a robust 11.74% yield, topping a field of contenders with rates in the 7%-range. Meanwhile, Switzerland (-0.11%) and Japan (0.03%) highlight the list of laggards, and the US’s modest 2.90% is firmly stuck in the middle tier, just as in the other two brackets.

                                                                       

Putting aside the fun-and-games aspect, this snapshot of global yields offers some interesting takeaways:

  • Inflation/Crisis Link. In general, the nations with the highest yields across the curve tend to have relatively large problems with inflation (Argentina, India, Nigeria), stagnant real economic growth (Brazil, Mexico), political troubles (Brazil, Turkey), or some combination of these issues. For example, the latest data on headline Argentinian inflation shows a 27% YoY increase!

Each of these factors impact sovereign bond yields, generally to the upside, and reflect a very rough ranking of relative credit risk for investors. Shakier borrowers should naturally offer greater yield (the credit “spread”) to compensate for the risk of price volatility and default.

  • QE/Monetary Policy. On the other hand, the lowest yields across the curve are consistently those featured on Eurozone, Swiss, and Japanese debt. This is no coincidence, as these nations’ central banks have established the “loosest” monetary policies in the world. A decade after the Great Financial Crisis, they are still actively engaged in Quantitative Easing, guiding many sovereign bond yields below zero in an attempt to stimulate investment and economic growth. An unprecedented situation in the history of modern global finance, the ultimate success (or failure) of these aggressive interventions has yet to be determined.
  • Credit Spreads and Hedging. Seeing the higher rates available in other countries, it’s natural to wonder whether it makes sense to simply buy the higher-yielding bonds. After all, if your choice is between buying a 2 Year US Treasury at 2.55% or a 2 Year Brazilian real-denominated sovereign bond at 8.69%, why even consider the US Treasury? In fact, there are several practical reasons why the differential is justified:
  • As mentioned above, Brazil is in the midst of a serious economic and political crisis which impacts its creditworthiness. As a result, Moody’s, Standard & Poor’s, and Fitch all assign a speculative-grade (“junk”) issuer rating.
  • Buyers of the Brazilian bond are paid principal and interest in Brazilian reals, not American dollars. To purchase them, an American investor would need to first convert their dollars into reals, and subsequently convert any real principal and interest payments received back into USD. The “round trip” net return in American dollars is thus heavily dependent on interim moves in the real-USD exchange rate, which can be exceptionally volatile.

In fact, just this year the real has declined in strength from 3.26 per dollar to 3.86 – an 18.3% YTD currency loss that more than wipes out the potential 8.69% 2 Year bond yield!

  • The previous scenario is an example of what’s known as unhedged cross-currency investing – that is, an investor is exposed to the upside and downside risk of moves in the underlying exchange rate. It’s possible to instead make this trade on a hedged basis, where the investor purchases an option that provides the right to exchange currencies at a known future conversion rate. Assuming the Brazilian bond doesn’t default, your potential round-trip net return in USD is thus known ahead of time with fairly precise certainty.

This is no “free lunch,” however, as currency hedging takes a huge bite out of the upside. For technical reasons beyond the scope of this discussion, most of the “cost” of buying a currency hedge is determined by the difference in short-term benchmark rates in the two currencies. In this case, that difference is substantial – upwards of 4.50% by our rough calculations, and additional markups and commissions would likely take the total annual price to at least 5%. When deducted from the potential 8.69% bond yield, this results in a net annual USD return of approximately 3.70%. That means a hedged investor has a much harder decision to make – is it worth holding speculative-grade Brazilian paper at only 1.15% more over the riskless 2-Year US Treasury?

  • Flat/Inverted Curves. Some countries feature curves that are exceptionally flat, inverted, or some combination of both, as opposed to the more normal positive-sloping curve. For example, Mexico’s rate structure is a real oddity – it’s both flat AND kinked in the middle!
  • 2 Year: 69%
  • 5 Year: 82%
  • 10 Year: 79%

Many factors contribute to this strange shape, including a complex interaction between different short vs. long-term inflation outlooks, speculation on NAFTA-related political turmoil, and fears of an impending economic slowdown. Just as striking, compare it to the lower, more upward-sloping Mexican curve from just two months prior (4/20/2018):

  • 2 Year: 30%
  • 5 Year: 32%
  • 10 Year: 49%

Suffice it to say, here’s a live example of how quickly modern financial markets can make improbable situations a reality.

  • Overall Rates are Still Fairly Low. Based on nominal GDP, the weighted-average 2, 5, and 10-year yields of these 32 largest global economies calculates to 1.92%, 2.69%, and 2.97%, respectively. It’s important to remember that eye-popping rates are the outliers, whereas financing conditions in general remain quite low compared to historical averages.
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This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.

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This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.