(PUB) Investing 2016

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Negative Yields Challenge Portfolio Managers Income Strategist | Karin Anderson

much damage to regional banks’ profits. The fund’s Japan stake is primarily in longer-dated government and agency bonds, a part of the yield curve that the team finds more attractively valued compared with longer-dated European debt. Despite the large stake in Japanese debt, the fund’s 1 . 9% SEC yield was in line with its average peers thanks in part to its 12% stake in higher-yielding emerging-markets bonds. That said, most actively managed world-bond funds have had underweightings to Japan and/or the yen during the past two years. For example, Loomis Sayles Global Bond ’s LSGLX 12% Japan stake came in 7 percentage points below its Barclays Global Aggregate Index benchmark, but its 1 . 4% SEC yield is below the world-bond Morningstar Category norm. A handful of managers with more flexibility have avoided Japan completely. Templeton Global Bond TPINX , which has the Citi World Government Bond Index as its prospectus benchmark, has had no Japan exposure for more than five years because its managers haven’t liked the country’s long-term funda- mentals and because of a general preference for higher-yielding bonds. That focus has kept the fund’s SEC yield on the high side for the category ( 3 . 8% as of July 2016 ). While its benchmark has 24% expo- sure to JGB s and the yen, the fund has a 40% short on the currency as part of a hedge for its hefty emerging-markets exposure (two thirds of bond exposure and four fifths of currency exposure). If the U.S. dollar strengthens versus the yen and other currencies, this poses a risk to the fund’s emerging- markets exposure, but under that scenario the short yen position would pay off. In the end, there is risk in choosing a world-bond index fund or exchange-traded fund over an actively managed option that has already dialed down Japan exposure or can tactically manage it. Vanguard Total International Bond Index VTIBX and similar passive options have more than 20% in JGB s, not to mention other negative-yielding European debt. K Contact Karin Anderson at karin.anderson@morningstar.com

Managing world-bond funds has become much more difficult. That’s because the overseas government bond market is awash with roughly $13 trillion in bonds sporting negative yields. Japanese government bonds, or JGB s, represent the vast majority of this debt, more than 4 times as much as France or Germany, which have issued the next-largest amounts. Given Japan’s prominence in global bond indexes (typically 20% – 35% of overall exposure), yields on those benchmarks have been feeling the crunch since the two-year JGB dipped into negative territory in December 2014 . This year, 10 - and 20 -year JGB yields slid below zero as well. Given the trend, yields on world-bond funds are lower, too. Japanese bonds may seem a necessary evil for these fund managers, especially those that need to align a fund’s risk/return profile with the benchmark. But JGB s can still be a useful tool. Many managers use them to some extent to balance a portfolio’s higher credit risks, and the yen has historically pro- vided ballast in times of market stress. Japan’s currency climbed by 23% versus the U.S. dollar in 2008 , for instance, and it also strengthened versus the dollar in more-recent risk-off markets. From a fundamental perspective, a negative-yielding JGB can still “roll down” capital gains as the bond matures and its yield falls, provided the yield curve maintains its shape. JGB s can also realize gains if Japanese interest rates slip deeper into negative territory. PIMCO Foreign Bond (Unhedged) PFBDX , which also comes in a U.S. dollar-hedged version, stands out for its heftier exposure to Japan, 39% of assets as of mid- 2016 . That’s 6 percentage points above its Barclays Global Aggregate ex- USD Index benchmark’s. The fund’s managers are comfortable with the over- weighting because they don’t think the Bank of Japan will push rates deeply negative, thereby destroying the roll-down effect, because that would inflict too