Bonds go global for better returns

Pension funds and insurance companies, which need such certainty, were natural buyers. But how things have changed.

Worldwide government bond yields are reaching all-time lows. Low inflation is partly to blame. As economies have become better managed, interest rates have fluctuated in ever-lower ranges.

At the same time, however, bond investors need to embrace higher risks to obtain higher income. Older and retired people need greater certainty and levels of income from their investments. Many state pension schemes are under-funded which means that they lack sufficient assets to match their future liabilities.

It has been estimated that even though Europe has a larger population than the USA, it has only one quarter of the pension assets. Some pension schemes are now closed to new entrants, or closed completely, in an attempt to avoid future liabilities that are unmatched by assets.

The UK-based Boots Company pension scheme famously switched all its assets into bonds some while ago. For those pension schemes that continue to be invested, the search has commenced for other sources of return.

One of the foremost proponents of global bond investment strategies, fund management house INVESCO has defined Global High Income as both global high yield and emerging market bonds, combined in a single portfolio.

Both of these asset classes have larger than average income yields, or coupons as they are known in the trade, to compensate investors for the higher than average perceived risk of default. But combining these asset classes can dilute such risks and still produce satisfactory returns.

Yields from bonds reflect investors' perceived risks. The actual risk tends to be lower, providing opportunities for discerning investors to benefit. Furthermore, these risks can be diluted in a portfolio through diversification.

The annualised return over the last 10 years on emerging market bonds has been 22.01%. On high yield bonds it has been 9.89%. This compares with the return on the S&P500 index of 18.35% [all sources Bloomberg to 31/3/02]. These performance numbers include periods of uncertainty, defaults and crises.

High yield and emerging market debt should not be compared but combined. The diverse characteristics can provide a complementary portfolio with a high income stream. Correlations with other asset classes also remain favourably low (0.10 with Global Bonds; 0.40 - 0.60 Global Equities. Source: INVESCO). Having some exposure to both asset classes dilutes the impact of specific future temporary loan interest defaults, an inevitable part of the investment cycle.

Specialised investment sectors are often not generally considered mainstream until they become part of broader market indices or portfolios. In Global High Income, that transition is now taking place.

Lehman Brothers last year introduced one of the most global fixed income indices, the Lehman Universal (JP Morgan and Salomons also have equivalents.) With over 5000 fixed income instruments, there is adequate choice, a diverse market and an increasing demand.

By some estimates Global High Income is already capitalised at over $4.5 trillion and is one of the fastest growing areas in fixed income. Meanwhile, the US government has been quoted as aiming to buy back all its debt by 2013.

The composition of global bond markets is changing dramatically. The question for fixed income investors, which includes pension funds, is not if to buy Global High Income but, when?