Key Points:

• Bond yields and prices share an inverse correlation
• Global government bonds have suffered over the past few months, but global bond funds have seen a wide array of returns
• Funds with large holdings in developed sovereign debt suffered over the recent period of rising yields
• Funds with higher levels of corporate debt holdings outperformed, while an actively-managed fund invested solely in sovereign debt also managed a positive return
• Investors who expect interest rates to rise can still invest in global bond funds, but should choose managers which are actively seeking to lower duration, or implement active strategies to deliver returns even if interest rates remain low or start to rise
• Short duration funds are also an option for investors who expect interest rates to rise

Chart 1: Bond yields rising

Bond yields and prices share an inverse correlation, which means that as yields rise, bond prices decline and vice versa. The past few months have thus been difficult for bond investors, as longer-dated bond yields rose from near-historically low levels on the back of stronger economic growth and inflationary expectations (see “Why Bond Yields have been on the rise”).

Bonds fell as yields rose, but mixed performance observed across global bond funds

For the benchmark 5-year US Government bond, yields rose from 1.127% on 7 October 2010 to a recent high of 2.3986% on 8 February 2011, a 127.16 basis point increase in just a little over four months. Likewise, the 10-year US Government bond yield rose from 2.3833% to 3.7373% over the same period, a 135.4 basis point increase in yield (see Table 1). Consequently, global bonds declined, with the Ryan Labs US Treasury Index declining a hefty 7.5% (in USD terms) over the period (see Chart 1). Interestingly, not all bond funds suffered as much over this period of rising yields (7 October 2010 to 8 February 2011). Table 2 indicates the wide disparity of returns turned in by global bond funds on the platform:

We note that the US dollar depreciated against the SGD by 1.3% over the abovementioned period, which has detracted from overall returns for some of the USD-focused global bond funds and explains a portion of their underperformance. However, with returns differing by as much as 10%, a closer look at the underlying fund strategy is certainly warranted.

Worst-performing bond funds largely invested in developed nation sovereign debt

The worst-performing global bond funds over the recent period of rising yields were largely invested in global government debt, which felt the full impact of yield increases. While the Legg Mason Global Bond Trst aims to maximise total returns in SGD terms, the fund’s benchmark is the Citigroup World Government Bond index (S$), which suggests that the fund is largely exposed to government debt – all 5 of the fund’s largest holdings at the end of December 2010 were developed nation sovereign debt securities. The January 2011 factsheet for the DBS Shenton Dynamic Bond fund also indicates a 94.2% allocation into sovereign debt, with the fund’s holdings largely in Germany, Japan and the US (as of 31 December 2010).

Outperforming global bond funds mainly invested in the corporate sector

With a 2% return (in SGD terms) from 7 Oct 2010 to 8 Feb 2011, the United International Bond Fd’s outperformance may have been due to its corporate debt focus (which may provide higher yields and are less correlated with global government debt). This is in stark contrast to the United Global Bond SGD which declined 7%, due to its focus on government bonds (92.58% of the fund was in Government securities, as of 31 December 2010). In addition, the geographical breakdown of the UOB International Bond Fund’s holdings (as of 31 December 2010) indicates a large exposure to the Asian region, with just 8.99% of the portfolio in the US. Like the UOB International Bond Fund, the LionGlobal Bond(Cl A) also had a tilt towards corporate bonds, with the fund’s latest factsheet (as of 31 December 2010) indicating that all of its top 10 holdings are corporate securities.

An actively managed global government bond fund managed to outperform as well

While the outperforming global bond funds over the recent period of rising yields were mostly invested in the higher-yielding corporate bond space, the Templeton Global Bond fund sticks out like a sore thumb. The SGD-hedged class of the fund (FTIF-Templeton Glb Bond A(mdis) SGD-H1) managed a 1.1% return over the period, despite its mandate which only allows investments in sovereign debt (the unhedged class of the fund lost 1.3% over the same period due to the depreciation of the USD against the SGD). So how did the Templeton Global Bond fund manage to outperform in an environment of rising government bond yields?

The fund’s strong showing boils down to the three sources of alpha the managers use to achieve and maximise total returns – duration, currency and sovereign selection. The fund manager has largely been benchmark-agnostic, and will adjust the portfolio’s duration and market selection according to its own macro view of interest rates and the global economy. In addition, active currency positions are undertaken to add an additional source of alpha. In recent communication, the fund’s manager continues to highlight that yields are unsustainably low, and the fund is positioned to capture upside should interest rates rise in the future. Measures undertaken involve a relatively short duration portfolio, as well as a short position on the Japanese yen due to its correlation with the US and Japanese interest rate differential.     

Expect interest rates to rise? Consider actively-managed global bond funds

While short-term yield movements tend to be rather volatile, the longer-term trend in bond yields paints a different story. As shown in Chart 2, the US 5-year Government bond yield currently trades near the lowest level since 1962, representing an extremely unattractive current yield. In addition to the unattractive yield, rising economic growth and inflationary expectations along with the poor US fiscal position suggest investors will begin to demand higher returns from bonds, which entail higher yields going forward.

Chart 1: Bond yields rising

While rising yields may hurt the returns on many global bond funds, investors will do well to select funds which extensively employ active management, and look not just to track a global bond benchmark, but also to beat it. Investors who expect interest rates to rise may thus wish to seek exposure to global bond funds which have a relatively low duration (and hence less interest rate risk) as well as funds which utilise currency views as a key strategy to enhance returns in a low-yield environment. One such fund is the FTIF-Templeton Glb Bond A(mdis) SGD-H1, and a check on the fund’s latest factsheet (as of 31 December 2010) shows a relatively low average duration of 2.3 years, while just 4.1% of the portfolio’s holdings are in the US, indicating that the manager’s actions are consistent with a view that interest rates are likely to rise in the future.

Short duration bond funds also an option

In addition to selected actively-managed bond funds, short-duration funds are suitable investment instruments in times of rising interest rates. Given the short maturities of the underlying securities, interest rate risk is minimised, while proceeds from maturing securities can be reinvested at higher interest rates should short term rates rise. Short duration funds managed from a SGD perspective include Schroder S$ Reserve Fund Cl A, Fullerton Short Term Int Rt C S$, DBS Enhanced Income SGD and United SGD Fund.

"Short Duration Funds – When Short is Stout" takes a closer look at short-duration funds on the platform.

Related Articles:

Short Duration Funds – When Short is Stout
Understanding Bonds: Are Rising Bond Yields Good For You?
Fund Focus: DBS Enhanced Income Fund
Bond Duration - What, How & Why?
Why Bond Yields have been on the rise