Mark Beischel, CFA
Waddell & Reed Advisors Global Bond Fund – April 2012
The Waddell & Reed Advisors Global Bond Fund has the capability to invest anywhere in the world, both inside and outside of the United States. Part of our strategy involves investing in emerging markets. In the following discussion, we describe what we believe makes the emerging markets attractive for bond investors. We’ll follow that up with a glimpse at the current portfolio that highlights our involvement in emerging markets.
Why invest in emerging markets? — Reason one: Improving credit quality
There is no question that investors take on risks when they invest in emerging markets. The rule of law, property rights, labor rules and conditions, political systems, openness to trade and capital flows, structure of markets, adherence to international rules, accounting principles — to name a few! — can all be very different between the U.S. and emerging countries. The key for investors comes down to one question — are you being fairly compensated for taking these risks?
Credit quality is an important risk consideration. All of us would agree that the rating agencies have not always done a terrific job, especially with regard to asset-backed securities prior to the global financial crisis. However, the agencies have fared better with regard to categories they have rated for decades — corporate bonds and sovereign credit. Today, as we have seen with regard to Europe and the U.S., rating agencies tend to be more proactive with sovereign ratings changes. When establishing or reviewing a sovereign credit rating, the agencies take into account all of those factors mentioned in the first paragraph of this section. So let’s take a look at rating trends in developed and emerging countries.
Chart 1 shows the ratings trends since 2000 for developed countries and emerging countries1. At the turn of the century, developed country average credit quality was AA+ — just a single notch below the top AAA rating. (as rated by Standard & Poor’s) Emerging countries, on the other hand, were about eight notches below developed countries, and a notch below investment grade quality.
The chart does a good job of demonstrating how the global financial crisis of 2007-2008 exposed the structural flaws in developed countries that took on unsustainable amounts of debt during the first part of the decade. Since 2008, developed country credit quality has dropped to an average of AA-, bordering on A+ — two to three notches below the 2000-2007 average. It may not seem like much at first glance, but the deterioration has been rapid over the past year, and many developed countries are in jeopardy of further rating declines stemming from slowing economic growth, fiscal austerity measures intended to relieve massive debt burdens, and poor demographic patterns.
Now, contrast the developed countries’ trend with the emerging countries’ trend. In 2000, emerging countries on average were rated just below investment grade (i.e., in the high yield, or junk category). Since 2000, the emerging countries have shown steady progress
— even demonstrating great stability during the global financial crisis. Average credit quality advanced two to three notches to the BBB+ level, well into the investment grade category. After starting about eight rating notches apart in 2000, the quality gap between developed and emerging countries has narrowed to three to four notches today. Finally, the prospects for many emerging countries are considerably brighter than that of many developed countries.
It is also important to understand that as sovereign ratings go, so go corporate ratings. Emerging market corporate bond ratings have also improved since 2000.
Now, you might be asking yourself: Is all of this improvement due to China, or perhaps even Brazil? The truth is, the improvement is across the emerging market spectrum. First of all, remember that this is an unweighted average; each country has the same weighting in the index. So China’s larger gross domestic product (GDP) or population has no bearing. Second, check out Chart 2, which breaks out the rating trends by geographic region — Asia, Eastern Europe, and Latin America2. As you can see, each region has had the same general improvement as the overall emerging country average shown in Chart 1. Asia has improved by two notches, Eastern Europe has improved four notches (driven mostly by Russia, as Poland’s credit quality has been reasonably stable over this period), and Latin America — despite Argentina’s descent between 2001 and 2003 — has improved three to four notches.
Why invest in emerging markets? — Reason two: Yield and valuation opportunities
Many of you will be familiar with Chart 3, as it has appeared in earlier Perspectives and in our presentations. The message of the chart is worth repeating — we believe there’s still a lot of bang for the buck in emerging market bonds, especially given improving credit quality and less attractive alternatives. As you look at this chart, please remember that there is no currency effect here — all of the bonds in these indexes are denominated in U.S. dollars. So we’re on an apples-to-apples basis. Each line represents the yield curve3 for the categories shown — U.S. Treasuries, U.S. BBB-rated industrial bonds, and foreign issuers with an average rating of BB. Investing in BBB bonds pays more than U.S. Treasuries, and investing in BB foreign bonds pays more than either U.S. BBB issuers or U.S. Treasuries. For example, note the solid vertical yellow bar, which intersects the yield curves at the 5-year maturity point. Today, while 5-year U.S. Treasury notes yield around 1 percent, BBB U.S. Industrial bonds yield about 2.75 percent and BB (U.S. dollar denominated) foreign issuers yield about 5 percent. Okay, so the yield comparison favors emerging market corporate bonds. But what about valuation?
Most investors would agree that investing in emerging markets is riskier than investing in the U.S. and other developed countries. Although geography does have something to do with risk, more often than not it is valuation that is more important in determining the degree of risk that an investor is actually taking. For example, was it riskier to buy tech stocks in the United States in late 1999, or to buy Brazilian equities after they elected their first ever left-wing president in 2002? Were you better off investing in Italian or Russian government bonds over the past two years? Would you have been as well-off buying a home in 2006 rather than today? Too often investors ignore valuation and instead get caught up in crowd behavior, bullish ravings from market pundits, and stories of a “New Era” in investing.
Chart 4 shows the long-term trend of selected corporate bond spreads (all U.S. dollar denominated). These spreads are representative of the additional yield an investor might receive on corporate bonds versus similar maturity U.S. Treasuries. The chart also shows the long-term average for each of those spreads. The three lines represent investment grade emerging market corporate bonds, low grade (high yield, or junk) emerging market corporate bonds, and high grade U.S. corporate bonds. As you can see, emerging market corporate spreads today are still above their long-term average, while U.S. corporate spreads are right on top of the long-term average.
Based on our analysis of emerging markets, we believe there is a positive story for the kind of bonds that go into the Advisors Global Bond fund.
But wait — isn’t the financial media telling you every day (more like beating it into your head with a 2x4 every day) that bonds are the risky investment, and stocks are cheap? This is where it is absolutely critical to understand that not all bonds and bond funds are alike.5 In the Advisors Global Bond fund, we don’t have to overextend the average maturity of the fund to achieve higher yields — we can maintain a shorter average maturity and gain additional yield by investing in corporate bonds — especially emerging market corporate bonds. Remember, the risk that the financial media always refers to when they talk about how risky bonds are is the risk that interest rates and/or inflation will start rising very soon. In a rising interest rate environment, bond prices tend to decline. If you own long maturity bonds, then yes, you will get a negative price impact from rising interest rates and inflation. But that’s not how the Advisors Global Bond fund is managed. Our corporate bond-focused strategy allows us to keep a much shorter average maturity; we also keep plenty of liquidity on hand in the form of cash and short-term Treasuries in an effort to take advantage of market opportunities.
However, for argument’s sake, let’s assume interest rates/inflation do begin to rise suddenly. What happens to the Advisors Global Bond fund? Initially, there would be some negative price (NAV) impact. However, the shorter average maturity of the fund means more money will be available more quickly to invest at higher rates as the bonds mature. Furthermore, the liquidity portion of the portfolio can also be used to capture the now higher rates. Not only does the shorter average maturity help to mitigate falling bond prices, but it allows us to more quickly re-invest in higher yields that have the potential to positively impact the fund’s dividend. Again, do not be afraid of bonds just because some market guru is telling you they are all risky. All bonds and bond funds are not alike.
Now, let’s consider the argument that today bonds are rich and stocks are cheap. One of the best measures of stock market valuation over time has been the Shiller CAPE — cyclically-adjusted price-earnings ratio.5 At today’s level, the Shiller CAPE indicates that the S&P 500 is over-valued by over 30 percent. But let’s be fair — not all stocks are overvalued, just like not all bonds are overvalued. Some stocks today trade at very good valuations. That’s why it’s important for fund managers and analysts to do their due diligence and find those values rather than just investing blindly in the market. Unfortunately, this is a lesson that must be continually re-learned.
Back in 1932, a market observer named Barnie F. Winkelman wrote a great book titled “Ten Years of Wall Street.” Winkelman detailed how professionals and non-professionals alike were caught up in the euphoria of the late 1920s, and forgot the importance of valuation when buying stocks and bonds. He stated this warning:
“Must it be reiterated that each purchase of stocks stands alone; that price and specific corporate facts determine whether it is a rash hazard or a conservative commitment.”
In other words, for stocks and bonds, valuation matters.
How does the Advisors Global Bond Fund invest in emerging markets?
Above, we discussed that the preferred investment vehicle for the Advisors Global Bond fund is corporate bonds. It’s important to remember that the U.S. bond market is the largest and most liquid in the world. Many emerging market companies are global players. Others are important to their domestic economy. However, local bond markets in emerging countries are typically not large or liquid enough to take care of all the financing needs of their local companies. Therefore, emerging companies have to go to the market where they can raise hundreds of millions or even billions of dollars at one shot — the U.S. bond market. This provides a terrific opportunity for U.S. investors to buy great emerging companies through bonds denominated in U.S. dollars. The Advisors Global Bond fund uses this situation to buy the bonds of what we believe are some of the best companies in the world — whether they are U.S. companies, Brazilian companies, Indian companies, German companies, or Indonesian companies.
Advisors Global Bond Fund portfolio update6
Emerging markets Here are some data that demonstrate our involvement in emerging market bonds, and in particular corporate bond issues from emerging countries.
- Emerging markets represent 57 percent of the Advisors Global Bond Fund’s assets.
- The U.S. is still the largest country exposure in the fund, at 34 percent of fund assets (including cash). However, the next six largest exposures are all emerging countries — Brazil, Russia, India, Argentina, Indonesia, and Mexico.
- Latin America represents 29 percent of the fund, Asia represents 18 percent, and Eastern Europe 9 percent.
Corporate bonds We mentioned earlier that corporate bonds are the preferred investment vehicle in the Advisors Global Bond fund, rather than government bonds or asset-backed securities. The Advisors Global Bond fund has 66 percent of fund assets invested in corporate bonds from around the world.
Currency exposure Approximately 98 percent of the fund’s bond holdings are denominated in U.S. dollars. The fund also utilizes currency forward contracts to gain currency exposure. The fund is currently short the euro and long the Chinese renminbi.
Maturity The most precise measure of a bond fund’s average maturity is the concept of duration. Duration takes into account all of the cash flows emanating from a bond investment, applies a time element, and discounts those cash flows back to today’s value. The Advisors Global Bond fund currently has a duration of 3.0 years. As a point of comparison, a 5-year U.S. Treasury today has a duration of 4.8 years.
We believe there are — and will continue to be — sound opportunities investing in emerging market corporate bonds. At the same time, we will continue to seek appropriate valuations for all investments in the fund. Our twofold approach for investors in the fund remains the same — provide a reasonable income stream, and manage the risk of permanent capital loss through fundamental credit analysis, low duration, and diversification. Many investors are starved for income, and remain cautious about taking too much risk after the tumultuous years since 2000. We manage the Advisors Global Bond fund for just that type of investor, and we remain dedicated investors in the fund ourselves.
1The countries in each index are listed in the chart, and ratings are unweighted averages. We used ratings from Standard & Poor’s for this exercise. Data are as of March 2, 2012.
2You might notice a few countries missing, e.g. Czech Republic, Uruguay, New Zealand. We created the averages using countries (a) in which the Advisors Global Bond fund is currently invested or has invested in the past, (b) where there is a viable local bond market, and (c) that have entities that issue bonds in the U.S. market. Although each of the three countries mentioned in this footnote would have some opportunities for global bond investors, the opportunities are far larger in the countries actually used in our indexes; furthermore, leaving them out doesn’t change the credit trends noted in the charts.
3The yield curve, according to Bloomberg, is a chart consisting of the yields of bonds of the same quality but different maturities.
4Bond spread is the difference in yield between a corporate bond issuer and a U.S. Treasury issue of the same maturity. The spread is measured in basis points; 100 basis points equals one percentage point. To determine the yield on a corporate bond, you need to know the U.S. Treasury yield of the same maturity and the spread. If the 10-year U.S. Treasury yield is 2.25%, and the corporate bond spread is 300 basis points, then the yield on the corporate bond is 2.25% + 300 basis points (3.00%), or 5.25%.
5For actual CAPE data, go to Shiller’s website, http://www.econ.yale.edu/~shiller/data/ie_data.xls. Information and interpretation of market valuation using Shiller’s CAPE can also be found at the Smithers and Company website, http://www.smithers.co.uk/page.php?id=34; Smithers has written two books analyzing the robustness of CAPE for market valuation.
6All data as of February 29, 2012.
The opinions expressed in this commentary are those of the fund managers and are current through April 4, 2012. The managers’ views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results.
Consider all factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. Investing in emerging markets may accentuate these risks. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.