An investor's guide to sovereign risk for pricing bond returns (Part 9 of 10)
Investors can profit from economic cycles
Differences in economic cycles and monetary policy across countries often provides the best opportunities to investors. International or overseas bond funds (EMB) can provide valuable diversification benefits to investment portfolios. The macroeconomic factors act as value drivers for bond returns—for example, interest rates, gross domestic product (or GDP) growth, inflation expectations, and employment—vary across countries.
International bond funds have been known to have low and negative correlations with domestic bonds , especially U.S. Treasuries. As a result, they can provide valuable diversification benefits for investors. The practice of allocating an investor’s portfolio across different asset classes is known as diversification.
A diversified portfolio—one where funds are divided among various asset classes like stocks, bonds, and real estate—would usually have lower risk than an undiversified portfolio. The factors that are significant value drivers for one asset class would have limited or no impact on another asset class.
Why differences in economic cycles matter
Generally, economic expansion leads to higher demand and inflation. The central bank is forced to raise interest rates. During a recession, the central bank faces the opposite problem—lower demand and inflation. This forces the central bank to lower interest rates. Since interest rates and bond prices move in opposite directions, this can significantly impact your bond investments. Savvy investors can leverage these differences to their advantage.
Why U.S. economic growth is great news for U.S. stocks, but not bonds
Due to recent improvements the U.S. economy, the U.S. Federal Reserve stopped tapering its monthly bond buying program in December, 2013. This led to an increase in U.S. Treasury yields in 2013. The Fed is also expected to raise the Fed funds rate sometime in 2015. This would impact the returns on U.S. Treasury exchange-traded funds (or ETFs) mentioned earlier like the iShares 20+ Year Treasury Bond ETF (or TLT) and 3.1% in total returns for the iShares 7–10 Year Treasury Bond ETF (or IEF).
However, other countries around the world could be following a looser monetary policy—for example, one where the central bank would lower rates. This would benefit bond investors. Their economies are showing low or negative growth. Lower interest rates would be expected to boost investments and generate employment and economic growth.
Major world economies that have recently announced or expected to follow an accommodative monetary policy include China (FXI), the Eurozone (EFA), and Korea (EWY). Lower rates would positively impact bond investments (PCY) in these countries.
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