With the Federal Reserve intent on holding the federal funds rate at 0%-0.25% until unemployment falls to 6.5%, or even 6.0%, U.S. savers require patience – it could be up to two years before any increases in short-term interest rates. Now that people are re-entering the labor force in an economy nominally growing at less than 4%, it ought to be a while before the employment picture has improved enough to warrant an increase in rates. By exposing themselves to foreign bonds in local currencies outside the US, investors hold some optionality to a long-term decline in the US dollar while earning an income stream. The traditional portfolio of stocks and bonds has evolved into a broader investment landscape for investors, including real estate, precious metals, private equity, hedge funds, and foreign currencies, which all seek to enhance returns while reducing risks to a portfolio.
In our opinion, simply knowing your investment objectives, risk tolerance, and underlying risks is the best way to survey the landscape. Investing in a no-load international bond fund such as the Euro Pacific International Bond Fund could be a good alternative. No-load funds still incur management expenses, but there is no sales charge, unlike funds sold with a load, oftentimes through a secondary party.
We believe that now is the time for investors to consider the risks in their bond portfolios. Unfortunately, sometimes risks aren't as apparent as they seem. Even looking under the hood of many bond mutual funds reveals little to the untrained eye. This was proven during the global financial crisis of 2008. A variety of bond mutual funds were caught “swimming naked,” as they were revealed to have actively used credit-default swap contracts in order to enhance returns.
Today, many international bond mutual funds actively use a variety of hedging techniques or financial instruments in order to mitigate risks or generate enhanced returns in a zero-interest rate environment. These hedges come with their own costs and risks, however. The Euro Pacific International Bond Fund is exposed to market risks, foreign investment risk, credit risk, interest rate risk (as bond prices fall when yields rise, a fund’s duration should be carefully considered before investing in a bond fund since a higher duration carries greater risk of falling bond prices if interest rates rise), liquidity risk, and management risk. It does not, however, have derivatives risk or counterparty risk.
Seeking diversification or non-correlated assets in today’s world remains a difficult task. The Euro Pacific International Bond Fund has a low R-squared compared to a common US investment-grade bond index, the Barclays US Aggregate Total Return Index. R-squared is a statistical measure that represents percentage point movements of a fund or security that can be explained by movements in a benchmark index. The 1-year* R-squared of the fund is 0.06, suggesting the fund little resembles the behavior of the broader US bond market. With respect to the US Treasury market, the fund has an R-squared of 0.00 as measured versus the 3-month T-Bill over a 1-year* time horizon.
Euro Pacific Asset Management doesn’t see the US economy as robust and able to sustain further significant rises in interest rates. With a surging US dollar, a European Union mired in debt that drags on growth, and a renewed Japanese policy determined to reflate the economy by means of depreciating the currency, the US dollar is a natural beneficiary of capital flows, but ultimately to its own detriment. A strong dollar is a headwind to foreigners seeking to take advantage of a weak dollar as they did in periods from 2009 through 2012 by buying up real estate, goods, and services from the US. This contribution to growth from foreign capital is no longer propelling growth, as can be seen in the most recent GDP figures.
In our opinion, over the last five years, local bond markets around the globe beyond G4 currencies (euro, British pound, US dollar, and Japanese yen) have gained in status as investors have remained concerned about their respective bond markets. The objective of the Euro Pacific International Bond fund is current income and capital appreciation invested in a diversified exposure to a basket of currencies that have been targeted by the investment team based on their fundamentals and potential for performance over the long-term. Investors could potentially benefit from additional developed and emerging market currency exposure.
When looking at international bond funds, carefully consider their high exposure to emerging markets, as well as their duration. With a potentially lower risk profile than some other international funds, over two-thirds of Euro Pacific's fund assets (69.5% as of 07/24/13) are invested in developed markets. The fund purchases government and corporate bonds with no exposure to asset-backed securities or credit derivatives. The fund has a medium duration. Therefore, moves in long-term interest rates have a muted effect on the fund’s value. Other international bond funds with a longer duration have significantly more downside risk should long-term interest rates rise.
With the health of the European banking system still in question, we find it prudent to limit our counterparty risk exposure. For this reason, we currently do not hold any derivative contracts to hedge foreign currency, credit, or interest-rate risk, but rather seek to manage these risks internally. Three prominent banks in Europe – Unicredit (Italy), Intesa Sanpaolo (Italy), and BBVA (Spain) – have five-year senior CDS trading over 300 basis points. Five-year senior Lehman CDS traded around 300 - 400 basis points in the two months leading up to its September bankruptcy, setting off a tidal wave of solvency concerns in the interbank market. There are no positions held in the Euro Pacific International Bond Fund related to the banks mentioned above.
With the S&P 500 hitting all-time highs, the abrupt selloff in the US Treasury market since the beginning of May, and even the rout in precious metals, it may be wise for investors concerned about capital appreciation with income to take a look at a fund such as the Euro Pacific International Bond fund. It is questionable that the strength of the US dollar will persist much beyond this year, considering that it has already risen 4.8% YTD (9.0% annualized)** after the average price of the US trade-weighted dollar index rose 3.8% in 2012 from its 2011 average. In 2008, a year when investors fled to safety in search of liquidity at the cusp of the credit crisis, the trade-weighted dollar had risen 8.4% by year-end. The recent volatility in currency markets creates opportunities to add exposure to bond markets outside the US now that Japanese government bonds and US Treasuries have lifted bond yields worldwide.