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 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

$-adjusted Monthly Excess Return (forward-hedged): Volatility

Predictive Variable 1: Relative Wealth

Predictive Variable 2: Beta

Predictive Variable 3: Term Structure Spread

Predictive Variable 4: Real Yield

Expected Returns Explained Variation (R-squared): Using Either Local or Global Factors

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

Sharpe Ratios (Annualized) - Global Portfolio of Bonds

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 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.