International Fixed Income

1. International Fixed Income Topic IVC: International Fixed Income Pricing - The Predictability of Returns

2. Outline • An introduction to why predictability is important • Framework • Main results • Summary

3. I. Why is predictability important? • Portfolio management • active trading among international bonds, tilting portfolio one way or the other • measuring risks • Helps answer some basic questions • can you forecast bond returns using current information • can you explain expected bond returns in terms of a simple, rational model

4. II. Framework • Recall that $-adjusted foreign bond returns can be broken down into two components: • foreign bond (in local currency) • exchange rates • Assume no currency risk, i.e, forward-hedged, so that we will look at predictability of bond returns (in own currencies)

5. Continued... • Look at six countries - US, Canada, Japan, Germany, France and UK. • Monthly excess returns of long-term government bonds over money-market rate, period 1978-1994. • The QUESTION - Are these returns predictable and what helps predict them?

6. IIIA. Main Results • Predictive variables • Factoids

7. Four variables • Weighted average of past wealth/Current wealth • Measure of market aversion to risk. • If current wealth low to past wealth, risk aversion goes up. • Expected excess returns must go up to compensate holding of long-term bonds.

8. Four variables continued... • Bond Beta • Bond return’s Beta with the overall aggregate stock market. • In practice, a regression of bond returns on the stock market return over the past 60 months.

9. Four variables continued... • Term Spread • The current spread between long-term gov’t and short-term gov’t bonds. • Theoretically, it tells us about expected future movements in the short-term rate and risk premia.

10. Four variables continued... • Real yield • Previous variable does not break down nominal rates into expectations of real rates and inflation rates. • This variable subtracts out an estimate of the expected inflation rate from the nominal yield to give an estimate of the real yield on long-term bonds.

11. Two Types of Variables • World • These are weighted averages of industrialized countries’ wealth, beta’s, spread and real yields. The weights are determined as % of GNP. • Country-specific • These variables reflect the country’s own wealth, beta, spread and real yields.

12. $-adjusted Monthly Excess Return (forward-hedged): Mean

13. $-adjusted Monthly Excess Return (forward-hedged): Volatility

14. Predictive Variable 1: Relative Wealth

15. Predictive Variable 2: Beta

16. Predictive Variable 3: Term Structure Spread

17. Predictive Variable 4: Real Yield

18. Expected Returns Explained Variation (R-squared):Using Either Local or Global Factors

19. Two Important Predictive Variables for Expected Excess Returns • Relative Wealth [Global] • Coefficient tends to be positive (magnitude around 7, w/ s.d. of around .1) - what does this mean? • Real Yield • Coefficient tends to be positive (magnitude around .3, w/ s.d. of around 2.5).

20. Example: Relative Wealth

21. Sharpe Ratios (Annualized) - Global Portfolio of Bonds

22. Some Additional Comments • Previous results suggest that expected returns across countries are highly correlated due to world factors: • True: between 0.87 and 0.98 • False: realized returns between 0.37 and 0.79 - what does this mean? • However, these expected returns on bonds are not highly correlated with expected returns on stocks.

23. IV. Summary of Last Few Weeks • Stylized Facts • Each country’s term structure can be explained by 2 factors - parallel shift and steeping/flattening • About 10-15% of this variation is predictable and common across countries; the remainder is obviously not predictable, and, for the most part, not common across countries

24. Summary Continued... • Implications of these results • Benefits to diversifying across international bond markets (though diminishes as country’s integrate, e.g. the Euro as an extreme) • Similar things drive bond markets in different countries, e.g., central bank policy, inflation expectations, real economy, ...

25. Summary continued… • Currency • For short-term foreign bonds, currency risk dominates due to its much higher volatility; obviously diminishes as maturity lengthens. • Possible to hedge out currency risk using forwards, which provides substantial advantages due to currencies moving apart from interest rates.

26. Summary continued... • Strategies • Evidence that either (I) dynamically adjusting currency positions, and/or (II) dynamically selecting between foreign bonds, and/or (III) dynamically selecting between long- or short- bonds internationally, produces excess profits, i.e., higher Sharpe Ratios, than passive strategies.