A Windfall from Foreign Bonds
Arthur Steinmetz of Oppenheimer International Bond Fund explains why he likes fixed-income securities from emerging markets
Despite the risks, foreign bonds have paid off in recent years for investors willing to weather volatility in exchange for higher returns. Oppenheimer International Bond/A (OIBAX ), managed by Arthur P. Steinmetz, head of Oppenheimer's international fixed-income team, looks for value and yield in both developed and emerging markets around the globe.
For the 12-month period ended Sept. 30, the $1.6 billion portfolio rose 11.6%, vs. 6% for the average global fixed-income fund. For the three-year period, the fund gained 18.2% annualized, vs. 9.1% for the peer group. For the last five years, it has risen 12.8% annualized, vs. 6.5% for its peers.
Given that Oppenheimer International Bond can invest in emerging markets, the portfolio is more volatile than its peer group, which is illustrated by its higher standard deviation. It also has a substantially higher annual turnover rate. The fund's expense ratio of 1.22%, however, is below the 1.29% peer group average. Based on risk and return characteristics over the last three years, Standard & Poor's gives the fund its highest rank of 5 Stars.
Steinmetz took over as sole manager in April, 2004, following the departure of Ruggiero de Rossi. However, Steinmetz has been on the management team in one capacity or another since the fund's inception in June, 1995. He also manages the Oppenheimer Strategic Income Fund (OPSIX ).
Palash R. Ghosh of Standard & Poor's Fund Advisor recently spoke with Steinmetz about the fund's investing strategy and top holdings. Here are edited excerpts of their conversation:
Q: How does the performance of foreign bonds correlate with the performance of U.S. securities?
A: There's actually a very high correlation between domestic bonds and the fixed-income markets of most of the developed world. For example, in 1994, U.S Treasuries sold off dramatically when the Federal Reserve enacted an aggressive tightening campaign. Interestingly, the German bond market also sold off by about 90% as much as the U.S., even though the German Bundesbank didn't move interest rates at all.
One major exception to this rule is Japan. Japanese bonds do not correlate with our markets, given that their business cycle has been out of whack with global economies for the past 15 years.
Q: What about emerging markets?
A: Emerging-markets bonds also have a low correlation with U.S Treasury bonds because they essentially provide a credit spread. By investing in emerging-markets securities, we add diversification to our portfolio and some protection against changes in U.S. markets.
However, most of the diversification that foreign bonds provide [to] investors comes from taking on currency exposure, and this is central to our investment philosophy.
Q: How do you assemble your portfolio?
A: We seek to create a broadly diversified portfolio by country, region, and currency to minimize volatility. We invest in both developed countries and the emerging markets. Our exposure to emerging markets provides us with a bit more yield than funds that invest exclusively in developed nations.
Essentially, through our investments, we're seeking an income advantage over U.S. markets. Currency is the most important variable in the construction of our portfolio. On a top-down, macroeconomic basis, the three most important global currencies are the U.S. dollar, the euro, and the yen. We evaluate the relationships between these three. The relative strengths and weaknesses of other currencies are of less significance.
Q: How is the fund currently positioned?
A: This fund operates on three different types of risk: interest rate risk, credit risk, and currency risk. At the moment, we're underweight in credit risk, underweight in interest rate risk -- by moving to shorter durations -- and overweight in currency risk.
Q: Do you invest in sovereign bonds or corporate bonds?
A: We're free to invest in both sovereign and corporate bonds. However, in practice, we usually have no exposure to corporates. The primary drivers of return are from currency risk and sovereign credit spreads. Any additional money we might make from buying high-grade corporate bonds would not enhance our overall returns.
We also avoid emerging-markets corporate bonds because they're especially problematic. The credit spread that these issues trade at doesn't compensate for the probability of a sovereign or corporate blow-up in these volatile markets. We find vastly better value and liquidity in sovereign bonds.
Q: What's your currency allocation at present?
A: We have about a 53% exposure to developed-market currencies, emerging markets denominated in U.S. dollars account for 19%, local emerging-markets currencies, 7%, and 10% is in U.S. currency.
We actually have an underweight in dollar-denominated emerging-markets bonds because we thought that rising U.S. interest rates would be a problem for the emerging markets and present a credit risk, but that has turned out not to be the case thus far.
Q: How has the portfolio changed over the last year?
A: We've reduced our interest rate duration as rates declined in the U.S. We've increased our exposure to emerging-markets bonds denominated in local currency, notably in Turkey and Brazil. We like countries with high real returns and declining inflation. Q: What is the fund's average credit rating?
A: It is currently at A+, but typically it's not that high since we're willing to invest in both emerging-markets bonds and below-investment-grade bonds. However, keep in mind that many emerging-markets bonds have witnessed upgrades to their sovereign debt in recent years.
Q: This fund generated big returns in 2002 (20.8%), and 2003 (25.9%). What drove this outperformance?
A: In 2002, we got big performance from emerging-markets bonds. In 2003, it was a combination of the continuing strength of emerging-markets bonds and the sustained weakness of the U.S. dollar.
Q: Why does the fund have such high annual turnover rates, as much as 300%?
A: The high turnover is a result of our investment methodology, and we think it's a spurious number. Currency hedging and active currency overlays are usually done on a 1- to 3-month rolling basis. Therefore, simply maintaining the positions requires several rolls per year, which inflates the turnover figure.
Q: Do you expect foreign bonds to outperform U.S. bonds as we head into next year?
A: Yes, and for two reasons: rising interest rates in the U.S. and the necessary correction in the U.S. dollar, which is ongoing. Interest rates are falling around the world, outside of the U.S. European bonds perform particularly well when the U.S. dollar weakens.
Despite the risks, foreign bonds have paid off in recent years for investors willing to weather volatility in exchange for higher returns. Oppenheimer International Bond/A (OIBAX ), managed by Arthur P. Steinmetz, head of Oppenheimer's international fixed-income team, looks for value and yield in both developed and emerging markets around the globe.
For the 12-month period ended Sept. 30, the $1.6 billion portfolio rose 11.6%, vs. 6% for the average global fixed-income fund. For the three-year period, the fund gained 18.2% annualized, vs. 9.1% for the peer group. For the last five years, it has risen 12.8% annualized, vs. 6.5% for its peers.
Given that Oppenheimer International Bond can invest in emerging markets, the portfolio is more volatile than its peer group, which is illustrated by its higher standard deviation. It also has a substantially higher annual turnover rate. The fund's expense ratio of 1.22%, however, is below the 1.29% peer group average. Based on risk and return characteristics over the last three years, Standard & Poor's gives the fund its highest rank of 5 Stars.
Steinmetz took over as sole manager in April, 2004, following the departure of Ruggiero de Rossi. However, Steinmetz has been on the management team in one capacity or another since the fund's inception in June, 1995. He also manages the Oppenheimer Strategic Income Fund (OPSIX ).
Palash R. Ghosh of Standard & Poor's Fund Advisor recently spoke with Steinmetz about the fund's investing strategy and top holdings. Here are edited excerpts of their conversation:
Q: How does the performance of foreign bonds correlate with the performance of U.S. securities?
A: There's actually a very high correlation between domestic bonds and the fixed-income markets of most of the developed world. For example, in 1994, U.S Treasuries sold off dramatically when the Federal Reserve enacted an aggressive tightening campaign. Interestingly, the German bond market also sold off by about 90% as much as the U.S., even though the German Bundesbank didn't move interest rates at all.
One major exception to this rule is Japan. Japanese bonds do not correlate with our markets, given that their business cycle has been out of whack with global economies for the past 15 years.
Q: What about emerging markets?
A: Emerging-markets bonds also have a low correlation with U.S Treasury bonds because they essentially provide a credit spread. By investing in emerging-markets securities, we add diversification to our portfolio and some protection against changes in U.S. markets.
However, most of the diversification that foreign bonds provide [to] investors comes from taking on currency exposure, and this is central to our investment philosophy.
Q: How do you assemble your portfolio?
A: We seek to create a broadly diversified portfolio by country, region, and currency to minimize volatility. We invest in both developed countries and the emerging markets. Our exposure to emerging markets provides us with a bit more yield than funds that invest exclusively in developed nations.
Essentially, through our investments, we're seeking an income advantage over U.S. markets. Currency is the most important variable in the construction of our portfolio. On a top-down, macroeconomic basis, the three most important global currencies are the U.S. dollar, the euro, and the yen. We evaluate the relationships between these three. The relative strengths and weaknesses of other currencies are of less significance.
Q: How is the fund currently positioned?
A: This fund operates on three different types of risk: interest rate risk, credit risk, and currency risk. At the moment, we're underweight in credit risk, underweight in interest rate risk -- by moving to shorter durations -- and overweight in currency risk.
Q: Do you invest in sovereign bonds or corporate bonds?
A: We're free to invest in both sovereign and corporate bonds. However, in practice, we usually have no exposure to corporates. The primary drivers of return are from currency risk and sovereign credit spreads. Any additional money we might make from buying high-grade corporate bonds would not enhance our overall returns.
We also avoid emerging-markets corporate bonds because they're especially problematic. The credit spread that these issues trade at doesn't compensate for the probability of a sovereign or corporate blow-up in these volatile markets. We find vastly better value and liquidity in sovereign bonds.
Q: What's your currency allocation at present?
A: We have about a 53% exposure to developed-market currencies, emerging markets denominated in U.S. dollars account for 19%, local emerging-markets currencies, 7%, and 10% is in U.S. currency.
We actually have an underweight in dollar-denominated emerging-markets bonds because we thought that rising U.S. interest rates would be a problem for the emerging markets and present a credit risk, but that has turned out not to be the case thus far.
Q: How has the portfolio changed over the last year?
A: We've reduced our interest rate duration as rates declined in the U.S. We've increased our exposure to emerging-markets bonds denominated in local currency, notably in Turkey and Brazil. We like countries with high real returns and declining inflation. Q: What is the fund's average credit rating?
A: It is currently at A+, but typically it's not that high since we're willing to invest in both emerging-markets bonds and below-investment-grade bonds. However, keep in mind that many emerging-markets bonds have witnessed upgrades to their sovereign debt in recent years.
Q: This fund generated big returns in 2002 (20.8%), and 2003 (25.9%). What drove this outperformance?
A: In 2002, we got big performance from emerging-markets bonds. In 2003, it was a combination of the continuing strength of emerging-markets bonds and the sustained weakness of the U.S. dollar.
Q: Why does the fund have such high annual turnover rates, as much as 300%?
A: The high turnover is a result of our investment methodology, and we think it's a spurious number. Currency hedging and active currency overlays are usually done on a 1- to 3-month rolling basis. Therefore, simply maintaining the positions requires several rolls per year, which inflates the turnover figure.
Q: Do you expect foreign bonds to outperform U.S. bonds as we head into next year?
A: Yes, and for two reasons: rising interest rates in the U.S. and the necessary correction in the U.S. dollar, which is ongoing. Interest rates are falling around the world, outside of the U.S. European bonds perform particularly well when the U.S. dollar weakens.
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