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World-Bond Funds Grapple With Japan's Negative Yields

Japanese government bonds' big role in global-bond indexes make them hard to avoid.

Karin Anderson, 08/25/2016

Managing world-bond funds has become much more difficult because the overseas government debt market is awash with roughly $13 trillion in bonds sporting negative yields. Japanese government bonds, hereafter JGBs, represent the vast majority of this debt, more than 4 times as much coming from France or Germany, which have issued the next-largest amounts.

Given Japan's prominence in global bond indexes (typically 20%-35% of overall exposure), yields on those benchmarks have been feeling the crunch since the two-year JGB dipped into negative territory in December 2014, and this year, 10- and 20-year JGB yields slid below zero.

In Europe, negative-yielding debt has become more prominent as well: two-, five-, and 10-year German bunds and Swiss government bonds across the maturity spectrum sport negative yields, for example.

Table 1 displays Japan exposure and yield to maturity for several bond indexes as of June 30, 2016.

Japanese bonds may seem a necessary evil for world-bond fund managers, especially those that need to align a fund's risk/return profile with that of the benchmark. But JGBs can still be a useful tool. Many managers use JGBs to some extent to balance a portfolio's higher credit risks, and the yen has historically provided ballast in times of market stress. Japan's currency climbed by 23% versus the U.S. dollar in 2008, for instance, and it also strengthened versus the dollar during the third quarters of 2011 and 2015 when emerging-markets currencies sold off. A negative-yielding JGB can still generate capital gains by rolling down the yield curve as the bond nears maturity, which would cause its yield to fall further if the yield curve maintains its current shape. JGBs can also realize gains if Japanese interest rates slip deeper into negative territory. However, there is the risk that if rates fall too far, the negative yield would wipe out any potential capital gains.

PIMCO Foreign Bond (Unhedged) PFUIX, which also comes in a U.S.-dollar hedged version, stands out for its heftier exposure to Japan at 39% of assets as of mid-2016, 6 percentage points above its Barclays Global Aggregate ex-USD benchmark's. The fund's managers have commonly had such tactical over- or underweightings to Japan. In the second quarter, they were comfortable with the overweighting because they did not think the Bank of Japan would push rates deeply negative, thereby destroying the roll-down effect, because that would inflict too much damage on regional banks' profits. The fund's Japan stake is primarily in longer-dated government and agency bonds, a part of the yield curve that the team finds more attractively valued compared with longer-dated European debt. The team kept the fund's yen exposure partly hedged to 25% of currency exposure, a firmwide strategic underweighting because of the country's less favorable long-term fundamentals, including its debt burdens and low growth potential. Despite the large stake in Japanese debt, the fund's 2.5% SEC yield was higher than two thirds of peers' thanks in part to its 12% stake in higher-yielding emerging-markets bonds.

That said, most actively managed world-bond funds have had an underweighting to Japan and/or the yen during the past two years. For example, Loomis Sayles Global Bond's LSGBX 12% Japan stake came in 7 percentage points below its Barclays Global Aggregate Index benchmark, which helped keep its 1.9% SEC yield just above the world-bond Morningstar Category norm. The fund's management team likes longer-dated JGBs in anticipation of the yield curve flattening and finds it too early to call the bottom on yields given ongoing uncertainty and too few catalysts for global growth. Still, the managers don't want to match the index weighting in negative-yielding bonds. The yen's appreciation during the first half of this year (up 17% versus the U.S. dollar) was partly behind the fund's increased exposure to the currency (18% and just below the index weighting). The yen's surge was driven by the BOJ's supportive moves, including its decision to hold monetary policy steady in April and June rather than easing further, as well as investors' increased appetite for it during tough periods like the post-Brexit vote.

A handful of managers with more flexibility have avoided Japan completely. Templeton Global Bond TPINX, which has the Citi World Government Bond Index as its prospectus benchmark, has been the most bearish on Japan. The fund has had no Japan exposure for more than five years because its managers haven't liked the country's long-term fundamentals and because of a general preference for higher-yielding emerging-markets bonds (two thirds of bond and four fifths of currency exposure). That focus has kept the fund's SEC yield on the high side for the category (3.9% as of June 2016). While its benchmark has 24% yen exposure, the fund has a 40% short on the currency as a hedge against an eventual rise in U.S. interest rates, a position that has proved costly amid the yen's strength against the dollar this year.

Another reason to avoid Japanese government debt is the risk of interest rates nudging upward, which could have a significant impact on a low-yielding portfolio. So even if JGBs have diversification potential, there is risk in choosing a world-bond index fund or exchange-traded fund over an actively managed option that has already dialed down that exposure or can tactically manage it. Investors in Vanguard Total International Bond Index VTABX and similar passive options likely have more than 20% in JGBs, not to mention other negative-yielding European debt. Table 2 displays Morningstar Medalist world-bond funds and their Japan exposure as of mid-2016 (all the funds' prospectus benchmarks include Japanese debt).



Karin Anderson is a senior mutual fund analyst with Morningstar.

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