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Non-Traditional Bond Indexes: Know the Bets They're Making

Patricia Oey

Patty Oey: Hi, we're here at the Morningstar ETF Conference. My name is Patty Oey. I'm a senior analyst on the Morningstar manager research team. I focus primarily on passive strategies.

I'm here today with Matt Tucker from BlackRock/iShares. He's the head of fixed-income strategy.

First of all, we're going to talk about international bonds. What are the traits of this asset class and why would investors want to hold it?

Matt Tucker: If you think about international bonds as a category, there are probably four major ways you can slice and dice that universe.

One is by developed market versus emerging market. It's very similar to how you think about developed-market equity countries being categorized versus emerging.

And then, do you want to invest in U.S.-dollar denominated debt or local currency? There are a lot of different ways to invest in international bonds, but if you think about those four different risk criteria or categorizations, it helps map out the universe and look at the opportunities out there.

Oey: Can you talk about the traits in terms of yield and duration versus U.S. bonds?

Tucker: Talking about duration is actually a great question. When we think about what duration measures, it measures the price sensitivity of a bond to changes in interest rates. But as U.S.-based investors, we think of that as changes in U.S. rates. If I'm thinking about a local-currency bond in Europe, that bond actually is not impacted by changes in U.S. rates. It has a different duration, which is a sensitivity to changes in local rates, in this case the euro rates.

People have to think about concepts like duration very differently. If I'm an investor in the U.S. investing in a European bond or European bond fund, if I'm investing in something that has local rate exposure, I've got a different kind of duration that's hard to match up to my U.S. duration. But if I'm buying a bond from The Republic of Italy, which might be denominated in dollars, that I can think of as having duration similar to how I think about the U.S.

The yield conversation has actually become very complex. As you know, we've been in a period where, globally, central banks have been lowering rates, implementing different forms of QE. Here in the U.S. we're toward the end of the QE program. But what it's meant is that rates are very low globally across developed markets. For investors looking at international markets, there aren't a lot of options in the developed markets for yield. People have tended to look toward emerging markets and local markets as places to find yield in this environment.

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Oey: iShares has a number of smaller funds that target different areas of the international bond market. Can you talk about which areas you think are more attractive? Do you like emerging-markets bonds right now?

Oey: We're seeing two pretty strong trends coming out. I think that you can put them both under the guise of looking for yield. Given this environment we are in, where U.S. rates are so low, where the Fed is keeping short rates low, where quantitative easing is pushing rates low across the curve, spreads on corporate bonds have come in, you only get paid about a percent more than a Treasury for buying a corporate bond. So a lot of investors in the U.S. have been looking for other options in the global markets.

One area they've looked is emerging-market bonds denominated in U.S. dollars. We have a fund, EMB, the Emerging Market Dollar Bond Fund, and it invests in a wide cross-section of issues from emerging-market sovereigns that all issue in dollars. This is an area where you can get just under a 5% yield and where you're taking on still some rate risk because these are dollar-denominated bonds--they have that U.S. duration--but you're getting some additional yield spread over what you can get in, say, investment-grade markets. That's an option we're seeing a lot of investors flock to.

The second one actually is on the local side, in high yield. There's been a big story over the last couple of years with a lot of investors moving into the high-yield market in the U.S., seeing it as a place to add yield to their portfolio. We're now seeing some investors step outside the U.S. We have a fund, HYXU, which is a global ex-U.S. high-yield bond fund. It gives you exposure to high-yield issuers in Europe and in Canada and other parts of the world, and that fund has seen some traction because investors are looking for a way to add yield. It has a yield of just under 4%, which, again, is going to be a lot relative to a lot investment-grade issuers locally.

Oey: And then for those two smaller asset classes, what are some of the risks that investors should focus on as well?

Tucker: Probably the biggest risk you've got to think about with any credit investment--and by credit I mean whether you're investing in a corporation or anyone else who may not repay the debt--you've got to think about credit risk. With emerging markets, that's always going to be a question, the willingness and ability to pay from the issuer. For that reason, we recommend funds like EMB, very diversified, with a broad cross-section of issuers. It helps to minimize your exposure to any one single default. There's been a lot in the paper recently about Venezuela and about some other issuers in the market. You want to make sure you're not overweighted to those types of issuers.

The other risk you've got to think about is currency risk. That's especially the case with the HYXU fund I talked about. There you have essentially from a U.S. perspective, a short dollar exposure and a long exposure to local currencies. Your return is going to be impacted not just by what happens to high-yield issuers in that local high-yield market in another country, but also by the movement in the exchange rate between the U.S. dollar and those other currencies. Investors have to think about that risk. Is that a risk they want? Or would they rather invest in the U.S.? Or perhaps they have a view on currency that is supported by that short dollar, long local currency view.

Oey: Let's talk a little about benchmarks, since we're talking about passive investing. Benchmarks tend to be cap weighted; that means maybe higher exposure to highly indebted countries or companies. Can you give us your view on that?

Tucker: I think on the surface, a lot of people come at it from this perspective, and say, if I'm looking at a sovereign benchmark--it could be an emerging market, it could be developed--and I apply the most weight to those issuers with the most debt, doesn't that create the tendency for adverse selection? Aren't I essentially lending the most money to those issuers who might have the least likely chance to repay that debt?

The challenge with that is, we find that the size of the issuance, the size of the debt from a country, is not always related to its ability to repay. Look at some of the largest issuers globally--whether it's the U.S. or whether it's Germany or whether it's Japan--these are also some of the strongest economies. So I think it's a fallacy to assume that the amount of debt outstanding is a direct driver of performance or investment appeal. People have to look deeper than that.

If you look at different indices that might have weighting schemes other than market-cap weighted, they may have some merit, but essentially what you're engaging in is an active process of some form. And we find in emerging markets, like in a lot of other markets, that about half the managers out there outperform the benchmark, and about half don't. It's not as easy as just saying, I'm going to choose a different weighting scheme for a benchmark. You have to think more critically about what that manager, or what that process, is and how it's deriving value. And in the end, it's probably going to be right about half the time.

Oey: Matt, thank you for sharing your thoughts.

Tucker: Thank you.