In Parts I and II of our Investing in Global Bonds series, we showed how a global perspective presents investors with a richer opportunity set and diversification advantages, as well as how this has historically translated into a superior risk-adjusted return profile within the sovereign bond space. In Part III of our series, we examine the historical risk and return characteristics of the remaining component of the global fixed income landscape: global credit. Our first objective is to examine the investment grade corporate bond segment on a standalone basis, and in contrast to domestic markets. Our second objective is to analyze all components of the credit landscape (including emerging market and high yield debt) in relation to one another and in relation to global sovereign bonds. In forthcoming papers, we will address the role of global bonds in an objective-oriented investor’s portfolio, as well as active management and implementation considerations.
Background1
In our last paper, we saw that the diversification inherent in a portfolio of global sovereign bonds can considerably reduce return volatility relative to a portfolio restricted to domestic government bonds; however, return enhancement is not a feature of this more diversified portfolio. Bonds with credit risk, on the other hand, will tend to offer varying spreads over government yields, as illustrated in Figure 1.
Source: PH&N Institutional, ICE Data Indices, LLC and JP Morgan. Average yield from December 31, 2019. Average credit rating as at December 31, 2019. For illustrative purposes only.
This characteristic of credit is related to an increased risk of issuers defaulting on their debt due to greater constraints on their ability to service the issued obligations. The three categories of credit we will examine in this paper are described below:
- Investment Grade (IG): Bonds issued by corporate entities considered to be stable, in good financial standing, with a healthy business and therefore at low risk of not being able to repay their obligations (“high quality”).
- High Yield (HY): Bonds issued by corporate entities considered to be less stable, potentially due to company immaturity, high levels of existing operating leverage, and other financial difficulties, thereby posing a greater chance of defaulting on their debt (“low quality”).
- Emerging Markets (EM): Bonds issued by governments or corporate entities from emerging market countries, usually with less developed economies prone to greater volatility, greater potential for political instability, and other socio-economic and political risks not typically associated with developed market countries. (We note that the spread component of local currency government issues is more driven by inflation/currency devaluation risk than explicit default risk).