Financial Education

International bond managers can seek excess return from a variety of sources:

1. Bond market selection – choosing the best country in which to invest
2. Currency selection – deciding whether to hedge or retain currency risk
3. Duration/yield curve management – getting the most favorable returns within the selected market
4. Sector selection – choosing among government, corporate, local currency or dollar-denominated bonds
5. Issuer credit analysis – being able to identify improvement or deterioration in advance of changes in rating
6. Benchmark mismatches – investing in markets that are not included in the benchmark index

Investor Specific Concerns

Strategic asset allocation starts with the investor’s objectives, constraints, net worth and attitudes toward risk. A risk tolerance function can be applied to determine the investor’s specific risk tolerance.

Capital Market Situation

The current state of the market must be identified, and some procedure used to generate a set of expected returns, risks and correlations between asset classes.

Joint Investor-Market Relationship

Given the investor’s situation and the capital market outlook, an optimizer can be used to determine an allocation suited to the investor’s risk tolerance. The asset mix can be selected, and actual returns fed back into the process as feedback.

Purchasing Power Parity

Purchasing power parity (PPP) is based on the belief that movements in exchange rates should offset any difference in inflation between two economies. Over longer time horizons, purchasing power parity does tend to hold, in part because governments take the concept seriously and act to control relative inflation rates. In the short term, however, other factors such as capital flows can overwhelm the impact of PPP.

Relative Economic Strength

This concept focuses on investment flows rather than trade flows. It suggests that strong economies attract capital, which causes the currency to appreciate. Foreign investors must always weigh whether the higher yield offsets the risk of inflated currency values. Relative Economic Strength indicates how currencies should respond to economic news, but does not imply a “true” currency value. Because of this, many investors use it in conjunction with PPP to form a complete theory of interest rate movements.

Capital Flows

Focuses on expected capital flows, particularly with respect to long-term capital investments. Capital flows can reverse the normal relationship between currencies and short-term interest rates, as the stimulative effect of a lower interest rate may outweigh the lower yield.

Savings-Investment Imbalances

This theory explains currency movements in terms of savings relative to capital investment. If domestic savings are insufficient to cover capital investments, the remainder must come from foreign sources. To the extent that foreign investment is not offset by a trade imbalance, the currency must rise.

Suppose an analysis finds that semiconductor sales have a strong relationship with semiconductor equipment sales. There are three possible explanations for the relationship:

1. Higher semiconductor sales result in a need for more semiconductor equipment (A predicts B)
2. Having more equipment to make semiconductors results in higher sales (B predicts A)
3. Some other factor (such as economic conditions) results in higher need for both semiconductors and semiconductor equipment (C predicts A and B)

Without investigating and modeling the underlying linkages, using correlations relationships in a prediction model can lead to significant errors.

Equally important, suppose that no correlation is found between semiconductors and semiconductor equipment. They may still have a strong (but nonlinear) relationship that should be considered. Such relationships may be found by using multiple regression techniques.

For individuals drawing on retirement funds, a 4% withdrawal rate is generally recommended to result in only a small chance of the portfolio running out of money. In the October 2007 Journal of Financial Planning Spitzer, Strieter and Singh simulate thousands of 30-year periods to assess the overall probability of running out of funds.

They find that a standard 50/50 split between stocks and bonds can allow for a 4.4% withdrawal rate with just a 10% chance of depleting funds. Withdrawal rates of up to 6% can be supported with stock allocations of 75% or more.

Portfolio management theory asserts, based on the variance between a given asset and the rest of the portfolio, that as few as 8-20 stocks are sufficient to provide most of the benefits of diversification.

In the November 2007 Financial Review Domian, Louton and Racine challenge this assumption by proposing that long-term investors are likely to be more concerned with shortfall risk (failure to reach a target ending wealth) than with return variance.

Based on the returns of 1,000 stocks and a safety first criterion, they find that at least 164 stocks are necessary to reduce shortfall risk to no more than a 1% chance of underperforming Treasury bonds. Although smaller portfolios can be enhanced by diversifying across industries, the benefit is not as powerful as that provided by simply adding more stocks to the portfolio.

When investing or considering investments in International assets, investors should consider the following special issues:

Currency risk: This affects both return and volatility. Investors must decide whether to hedge this risk.

Correlations with other assets: Although international assets frequently have low correlations with domestic assets, the correlations increase during times of stress. Times of stress are exactly the times in which a low correlation (higher diversification benefit) is most needed.

Emerging markets: Emerging markets tend to be less liquid and less transparent than developed markets. Their investment return distributions tend to be non-normal, which is significant for investors employing mean-variance optimization strategies.

Cash

Cash managers can earn higher returns by accepting longer-dated maturities or credit risk. The yield curve reflects the consensus expectation for future interest rates. Managers must distinguish between future events that are reflected in the yield curve adn those that will surprise the market.

Nominal Default Free Bonds

Conventional government bonds of developed countries have little or no default risk. Return can be disaggregated into real return and an inflation premium. The investor must compare his own forecast for inflation with that imbedded in the yield. If the investor believes inflation will be lower than expected, the bonds are a good buy.

Defaultable Debt

Default risk in commercial bonds is reflected in a premium yield relative to Treasuries. This spread tends to widen in recessions as economic stresses increase the likelihood of default. Understanding when a bond is pricing in greater default risk than is necessary can help determine whether securities are attractively priced.

Emerging Market Bonds

The sovereign debt of non-developed countries is often priced in foreign currencies. Since the issuer cannot print the money needed to cover repayment such bonds are subject to default risk, similar to corporate debt of similar ratings. A country risk analysis often involves an understanding of local politics.

Inflation Indexed Bonds

Inflation indexed bonds allow investors to directly observe the consensus inflation forecast by comparison with the yield of conventional bonds. The yield curve will still vary with the real economy and according to supply and demand. However, higher volatility of inflation will increase their hedging value and can result in lower real yields.

Common Stock

The economy affects earnings (cash flows) and interest rates in opposite directions. Trend growth depends on labor growth, investment and productivity while the business cycle affects profitability. In emerging economies, ex-post risk premia have been higher and more volatile than in developed countries.

Real Estate

Returns are affected by growth in consumption, real interest rates, the term structure of interest rates and unexpected inflation. Economic cycles can also affect the cost of building materials and construction labor, but the net effect of lower interest rates is positive for real estate valuations.

Currencies

Exchange rates reflect the balance between supply and demand. Imports increase currency supply, usually reducing its value. Capital flows for investment purposes, however, may outweigh the effect of trade imbalances. Differences between local interest rates can also affect exchange rates, as the higher yielding currencies attract capital and thus the currency value.

Historical averages incorporate many different types of economic environments, only some of which may be relevant to current conditions. One of the most important areas for investors to apply subjective judgment and insights is in “conditioning” historical data or choosing the periods that best reflect current conditions.

Even when using conditioned data, it is important for the analysis to incorporate any new facts that may be relevant to the decisions being made.

A Monte Carlo approach takes the probability distribution to generate multiple “paths” of possible return outcomes over time. It is superior to steady-state (deterministic) approaches to forecasting because it incorporates variability over long time horizons and illustrates how the resulting paths affect ending wealth.

Monte Carlo simulations generate probability estimates of ending wealth rather than a single point estimate. As a result, they more closely approximate likely investment outcomes.  They also provide insight as to the trade-off between short term risks and long-term potential of failing to meet the investment objective. The simulations can also incorporate multiple tax scenarios.