In their global search for yield, investors are pouring assets into a one-of-a-kind fund they might not understand.
Yields on all types of high-quality U.S. bonds have hovered near all-time lows for the past couple of years. U.S. Treasuries continue to defy expectations, their yields sinking still lower this summer on concerns about the health of the U.S. economy, political wrangling over the debt ceiling, and no end in sight to the eurozone's sovereign debt crisis.
In an effort to get away from these low yields and the threat of rising interest rates in the United States, some investors have turned to world-bond funds. One in particular has emerged as investors' go-to choice for global-bond exposure. Since flows into world-bond funds turned positive in May 2009, Templeton Global Bond
The fund's popularity clearly owes much to its outstanding record. In the past five years, it gained 11.7% per year on average, beating every other fund in the category and outlegging the Citigroup World Government Bond Index by an average of 380 basis points a year without producing additional volatility. Analytics such as the Sharpe ratio give the edge to a handful of U.S.-dollar-hedged world-bond funds that don't take any currency risk, but this fund has otherwise produced an excellent risk/reward profile. Meanwhile, investors craving diversification have also enjoyed a very modest correlation to the Barclays U.S. Aggregate Bond Index in the past five years that's lower than all but one other fund in the category.
Many investors who've piled into this fund, however, may be surprised to learn just how offbeat it is. Even as it has nearly quadrupled in size during the past two years, its portfolio has shown no sign of shedding its idiosyncratic qualities. By betting on China's economy and shedding interest-rate risk, the fund could be taking its boldest stance yet.
Not Just Another Pretty Face
The world-bond category contains a hodgepodge of strategies that can result in a wide dispersion of returns in any given year. Some funds stick to investment-grade government debt; some hold a sizable amount in corporates and other credit sectors; some hedge all of their currency exposure back to the dollar; some sync up their currency exposure to global bond benchmarks; some include the United States in the mix while others exclude it; and a few forge their own path, while paying little heed to traditional guideposts.
From the start, manager Michael Hasenstab's investment style has fallen into the last camp. Unlike managers who construct their portfolios relative to traditional issuance-weighted benchmarks, Hasenstab argues that those indexes don't make good investment sense. By design, they're heavily skewed toward the world's most indebted countries. The JPMorgan GBI Broad Index's largest country weightings, for example, are Japan (30%), the United States (29%), and the eurozone (27%). Given that many of those countries' gross debt/GDP ratios now approach 100% or greater, it's understandable why he's looking elsewhere. The ongoing sovereign debt crisis in Europe and this summer's debt ceiling negotiation debacle in the United States have only brought these long-festering problems front and center.
Other fund managers have caught on to this story in recent years, but when it comes to ignoring benchmarks, Hasenstab was ahead of his time. He has avoided U.S. and Japanese government bonds for years; the fund's exposure to eurozone debt has fluctuated around just a few percentage points and hasn't included any of the bloc's less fiscally responsible actors, including big benchmark constituents Spain and Italy. Instead, Hasenstab has favored the debt and currencies of countries with strong or improving fundamentals--such as low levels of indebtedness, prudent fiscal and monetary policy, and good growth prospects--where he thinks the market doesn't fully appreciate their worth, regardless of whether they're in the index.
Hasenstab and his team try to spot these opportunities early, however, and are willing to watch the thesis unfold over several years. The fund held a double-digit-sized stake in South Korea's government bonds going as far back as 2004, for example. That stake was recently as high as 16% of assets, even though the solidly investment-grade-rated country isn't included in the Citigroup World Government Bond Index; other top bond and currency holdings--including Australia, Malaysia, Poland, and Sweden--either take up a sliver of real estate in the benchmark or none at all. But they're all longtime holdings that fit a similar pattern.
Hasenstab doesn't demand fiscal perfection, though. Sometimes just getting on the right trajectory is good enough. He initiated a position in U.K. gilts with short maturities earlier this year (recently 5% of assets), for example. The country's gross public debt tops 80% of GDP, and its growth has been negative. But Hasenstab is encouraged that the government undertook the kind of tough fiscal reforms upfront that the United States continues to put off--which he argues improves its longer-term prospects relative to Uncle Sam's.
The Virtues of Independence
Hasenstab's unconventional moves can pay off handsomely. During 2008's global financial crisis, for example, he was concerned that slumping growth in the largest developed economies would be felt in the emerging world, too. Even though he continued to avoid Japanese government bonds, he beefed up the fund's exposure to the yen (roughly 30% of assets) and the Swiss franc (13%), which he believed would help the portfolio in case of a global bout of risk-aversion, while hedging away the fund's exposure to vulnerable emerging-markets currencies such as the South Korean won and Mexican peso. Those moves saved the fund a lot of pain; the won dropped 39% relative to the dollar from the start of 2008 through February 2009, and the Mexican peso dropped 28%. Meanwhile, the Swiss franc lost much less than most currencies relative to the dollar (just 3%), while the yen appreciated 14%.
And rather than hold his nose and buy U.S. Treasuries to benefit from their plunging yields, Hasenstab looked to take interest-rate risk in emerging-markets countries with better long-term fundamentals where he thought central banks would also eventually cut rates to combat slowing growth, including Chile, South Korea, Mexico, and Indonesia. Those countries' central bankers did just that, and the fund benefited from declining yields in those countries (but without exposure to their currencies in the case of South Korea and Mexico).
It wasn't all roses, though. Plenty of other positions worked against the fund that year, such as going long the Polish zloty and other peripheral European currencies against the euro. But overall, Hasenstab's moves helped the fund earn 6.3% in 2008, while some other world-bond funds with sizable stakes in emerging-markets bonds and currencies suffered losses. Then, after emerging Asian and Latin American currencies plunged in value versus the U.S. dollar (to record lows in some cases), Hasenstab quickly removed the hedges in early 2009 and added exposure to beaten-down bonds and currencies, allowing the fund to benefit from their rebound that year. As a result, the fund gained 19% in 2009, beating the Citigroup World Government Bond Index by 16 percentage points. All told, Hasenstab's flexibility and savvy maneuvering meant Templeton Global Bond was the only fund to land in the world-bond category's best-performing quartile in these two very different years.
China Looms Large
The fund's rapid growth in recent years hasn't tamed any of its eccentricities, either. Unlike in 2008, when Hasenstab thought slumping growth and deleveraging in the largest developed economies would affect the emerging world, he's no longer convinced that the sovereign debt crisis in Europe or the U.S. economy's torpor pose the same challenge to the rest of the globe. Indeed, much of the current portfolio's health hinges on continued economic strength in China and its gradual opening to foreign capital flows.
Hasenstab is expressing that view indirectly through the bonds and currencies of China's close trading partners in Asia, but that doesn't make it any less pronounced. The fund's 44% stake in Asian-government bonds and 57% long exposure to Asian currencies show how important China is to the fund's continued success. The contrast with most bond indexes is stark. Again, because of the region's low level of indebtedness outside of Japan, these countries represent just a few percentage points in traditional global-bond indexes; developing Asian countries are also the minority in emerging-markets bond indexes.
Its understanding of various countries' links to China has pushed the team to take a rosier view on the valuation of certain bonds and currencies than some competitors do. Hasenstab's comanager, Sonal Desai, recently noted that the Australian dollar looks overvalued according to traditional models, for example. She says, however, that these models don't fully account for how Australia's commodity exports should continue to feed a resource-hungry China. By her estimation, the Australian dollar and other Asian currencies still have room to strengthen in coming years because of their trade links with China.
And the China links don't end in Asia. Hasenstab argues that Poland's economy should continue to benefit from close trade ties with Germany, for example. Much of the inputs for German exports come from Poland and other countries in central Europe, which are ultimately tied to Asian demand.
In addition to the China-growth theme, Hasenstab has prepared the fund for an eventual rise in bond yields in the United States and most other markets. He has emphasized bonds that mature in the next year or two in most countries he favors, shortening the fund's overall duration (a measure of interest-rate sensitivity) to 1.7 years as of June 30, down from 5.2 years in mid-2009. In addition, he has shorted the yen (between 15% and 20% of net assets for much of the past two-and-a-half years) as an indirect play on rising Treasury yields. He believes Japan's monetary policy will need to stay loose longer than the Federal Reserve's--even despite Ben Bernanke's stated intention to hold off on interest-rate hikes for another two years--and argues that an eventual widening in the differential between U.S. and Japan interest rates should cause the yen to depreciate against the dollar.
What Could Go Wrong?
Hasenstab's Asia-growth and higher-rates themes are also the greatest risks facing the fund today. Those who share Hasenstab's aversion to low Treasury yields will be pleased to see that the fund's correlation with the Barclays Capital U.S. Treasury Index since the start of 2009 has dipped below zero, the sixth-lowest of any world-bond fund. Yet, its correlation with S&P 500 Index has risen to 0.82, which is the highest in the category excluding two other funds Hasenstab runs. That appears intentional; Hasenstab argues that owning any risky asset is effectively a bet on China these days. But while it has been mostly advantageous so far, it has also produced some momentary setbacks.
When equities and high-yield corporates sold off in May 2010, for example, many of the fund's currencies also quickly depreciated against the U.S. dollar. The Australian dollar, South Korean won, and Norwegian krone were the worst, dropping between 8% and 10% that month. Those currencies bounced back, but the fund lost 4.2% during that month, a worse result than most competitors'. A somewhat milder but similar scenario weighed on the fund in August; it dropped 1.1% during the month while the Citigroup World Government Bond Index notched a 2.1% gain.
A longer period of lagging isn't out of the question, either. Despite the yen's fundamental challenges, it has been obstinate, much to the consternation of Japanese policymakers who've taken steps to halt its rise this past year. Overall, Japan's currency appreciated 22% against the dollar since the start of 2010 through Aug. 31. Long-term U.S. Treasuries have also defied many investors' expectations by rallying furiously this year. As a result, the fund's stance on interest-rate risk and the yen has cost it relative ground so far in 2011. The fund's 4.9% gain for the year to date through Aug. 31 trails the Citigroup World Government Bond Index by 370 basis points and about two thirds of the world-bond category.
Global bond yields could easily stay low for a while longer yet. A slowdown of unforeseen magnitude in China could also throw the fund for a loop. Hasenstab is more comfortable than some about the prospect of China's GDP growth slowing from double digits to 7% or 8%, and he thinks that the country's $3 trillion in reserves gives it plenty of leeway to combat a slowdown. But a significant derailment of China's growth engine still poses a risk to the fund. On the other hand, if growth remains strong, Asian policymakers will need to continue taking proactive steps to prevent overheating and asset-price distortions. That will be a prerequisite for this fund's health, as well, particularly as extraordinarily loose monetary policy in the United States, Japan, and some European countries continues to flood the emerging world with liquidity.
The fund's rapid growth also deserves some attention. Including other accounts run in a similar style, Hasenstab now runs more than $100 billion. Asset growth can be problematic when it forces managers to invest in a way that makes their portfolios look more like the broader market. But as noted, the fund's portfolio doesn't appear to be in any danger of becoming ordinary. Size can also make it challenging to adjust a fund's allocations quickly. That risk is partly lessened here by Hasenstab's long-term approach; it's unusual to see him trade rapidly into or out of countries' bonds, and currency markets tend to be very liquid. Still, given the fund's modest-size positions in some smaller, below-investment-grade-rated markets, it could take some time to get out of them if an investment thesis deteriorates.
So far, the fund's growth appears manageable but bears watching. Flows have gone only one direction for much of its history, and it remains to be seen how well the fund could handle a period of sustained and heavy outflows, especially if a rough patch of performance rattles the nerves of newer investors who have piled into the fund in recent years.
Know the Risks
By acknowledging the fund's risks, we're not suggesting Hasenstab and his team can't continue to manage them effectively. The team's thoughtful process, meticulously detailed country research, and success in navigating very difficult terrain in previous years inspire confidence.
But while Hasenstab's distinctive approach is one of the fund's greatest strengths, its risks haven't yet manifested themselves in a major way. The fund's strong absolute and relative showing during a frightening 2008, as well as its moderate volatility over the long term, could lull some investors into a false sense of security.
Moreover, the risks facing the portfolio today deserve careful consideration. Its increased correlation with risky assets in particular should cause investors to think about how they're using the fund in an asset-allocation scheme. Patient investors are likely to be rewarded here, but those who think they're signing up for traditional global-bond exposure should think again.