As the Japanese government continues to issue bonds and the US government buys back more debt, fixed...
As the Japanese government continues to issue bonds and the US government buys back more debt, fixed income fund managers are having to cope with the havoc this is wreaking on their benchmarks.
Fund managers are contacting their clients with a view to renegotiating their contracts in order to allow them to change benchmarks to fit an unprecedented change in the global bond markets.
To avoid high tracking errors, managers have had to pull money out of the US bond market and into low-yielding Japanese bonds. Over the last five years, the US share of the JP Morgan Global Bond Index has dropped from 43% to less than 30% while Japanese government bonds (JGBs) have moved from 12% to 23%.
The Salomon Global Government Bond Index is even more extreme, Japan having overtaken the US. However, the US offers far higher yields.
Ian Donald, director of fixed income for Lazard, said: "The yield on 10-year Japanese bonds is about 1.5% compared to 6% for a US treasury bond."
Dominic Pegler, fixed income manager for JP Morgan, said: "The fundamental issue when you make an allocation to global fixed is what exposure do you want? In the past it was easy - you wanted government bond exposure, perhaps 35% in the US, 30% in the area covered by the euro zone, 18% in Japan and maybe 8% in the UK.
"The way the market performed in the past, you could get a decent return and the scope to spread risk. Supply of bonds ex-Japan is now falling, so opportunities to spread risk are less. Everywhere else budget deficits are falling and in the US and the UK there are debt buy-backs. The debt/GDP ratio in Japan is now on a par with that of Italy, Belgium and Brazil, which, given the size of the Japanese economy, is a worry."
Headline yields can be misleading, according to Pegler. If JGBs are hedged back into dollars, they can achieve an annualised 6.5% return. But this could change as JGB yields start to rise.
Pegler said: "JGB yields will get higher over the next three to six months - back up their historical levels of 3%-4%. These are capital losses and no hedge will save you from that."
One solution to this pending problem is simply to underweight the Japanese portion of a fund relative to its benchmark, but this would increase the relative volatility of the fund. The second option is to fashion a bespoke benchmark.
Donald said: "We will review with clients to see if we should create a customised benchmark that does not include all of the Japanese component."
However, Japan should not be cleansed entirely from benchmarks. US bonds largely dictate the performance of bonds globally and Japan is the only major non-correlative market.
Pegler's suggested solution is to include corporate bonds into the benchmark. These high-return vehicles are much in demand by investors as they offer significantly higher rates of return than government bonds, with a significantly lower risk than equity investments. The overwhelming majority are issued in the US, which would help rectify the US/Japan imbalance seen in the current benchmarks.
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