International Fixed Income

Topic IVC: International Fixed Income

Pricing -The Predictability of Returns

Outline

• An introduction to why predictability is important

• Framework• Main results• Summary

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

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)

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?

IIIA. Main Results

• Predictive variables• Factoids

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.

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.

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.

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.

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.

$-adjusted Monthly Excess Return (forward-

hedged): Mean

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

UK JPN CAN FRA GER US Global

Mean

$-adjusted Monthly Excess Return (forward-

hedged): Volatility

0

0.5

1

1.5

2

2.5

3

3.5

UK JPN CAN FRA GER US Global

Vol

Predictive Variable 1: Relative Wealth

0.920.9250.93

0.9350.94

0.9450.95

0.9550.96

0.9650.97

0.975

UK JPN CAN FRA GER US Global

Mean

Predictive Variable 2: Beta

0

0.05

0.1

0.15

0.2

0.25

0.3

UK JPN CAN FRA GER US Global

Mean

Predictive Variable 3: Term Structure Spread

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

UK JPN CAN FRA GER US Global

Mean

Predictive Variable 4: Real Yield

00.40.81.21.62

2.42.83.23.6

44.4

UK JPN CAN FRA GER US Global

Mean

Expected Returns Explained Variation (R-squared):

Using Either Local or Global Factors

0

3

6

9

12

15

UK JPN CAN FRA GER US

LocalGlobal

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).

Example: Relative Wealth

0

3

6

9

12

15U

K

JPN

CAN

FR

A

GE

R US

Glo

bal

Coefficient

Sharpe Ratios (Annualized) - Global

Portfolio of Bonds

0

0.2

0.4

0.6

0.8

1

1.2

Passive Dynamic(scale)

Dynamic(1/ 0)

Sharpe Ratio

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.

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

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, ...

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.

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.