The Case for Global Bonds
An important allocation for diversification and sustainability
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The Case for Global Bonds: An important allocation for diversification and sustainability
Craig Churman: So, I do want to welcome everybody to our sustainable series. This is Craig Churman, I’ll be the moderator today. This one... this topic, actually, has been in discussion within Saturna and with clients for several months, now. The Case for Global Bonds, Patrick was working on a white paper for a while and we’ll have Patrick Drum join us in a bit, and Elizabeth Alm, who did a lot of work on our Impact Report, will be joining us to share some of the insights they have on sustainability and diversification and how global bonds fit. But I want to introduce Gus Grefthen because Gus is our internal salesperson and Gus has been getting a lot of questions over the last few months from various advisors on different topics that relate to, “How do global bonds fit into sustainable strategies and how do they fit into client portfolios?” and there’s a number of topics that Gus has had to share, including sharing our impact report. Gus, welcome to the meeting and thanks for joining us. I know you know many of the advisors that we talk to on a regular basis and that you field calls with. “Help me understand your strategy and how does the global sustainable strategy fit into client portfolios?”
Gus Grefthen: Yeah, absolutely. Thanks for the introduction, Craig. It’s nice to be here and to be able to see some faces and yeah, just be a part of the call. So, yeah there’s a couple of common questions I have been hearing out in the advisor community. So, you know, one sort of general question is, “Where does the global bond strategy fit?” and, you know, what is a good way to position it as fixed-income allocation as brought up with their clients. You know, I’ve heard some shy away from bringing up the global bond category as a whole because they are unsure how to articulate and develop a good story to tell around emerging market debt. You know, not to mention that a few concerns around performance in contrast to, say, more heavily concentrated US bond funds.
Craig Churman: Yeah, and you know, we’re going to have Patrick speak pretty soon and Elizabeth speak pretty soon, and then we’ll field questions. So, if you have a question, add it to the chat and like Gus said, this topic has come up frequently in terms of both positioning the strategy but also how it fits in overall and you know, we still get a lot of requests for stories. So, Gus has been sending lots of copies of the Impact Report out and Elizabeth will join us at the end to talk about, you know, the underpinnings of our strategy and how we see both impact and sustainability in our portfolios. So, now I want to turn it over to Patrick Drum, who many of you know. Patrick is the lead portfolio manager on the Saturna Sustainable Bond Fund. And it is a global fund with a mandate for capital protection and income. And welcome, Patrick, and thank you.
Patrick Drum: Thank you. Thank you everyone this morning for joining and addressing or at least participating in our conversation on global bonds. My experience is that a lot of folks are not particularly familiar... or at least fixed income, in themselves, is not a particularly familiar landscape. And for those who are experienced investors, the familiarity may extend much more to US markets, but when you start moving and creeping outside the US borders, looking internationally, you start observing a bit of the familiarity kind of ceases. And it’s a bit of that home bias. Our job here is to kind of help elevate that conversation and offering that opportunity to get you a little more familiar. I think one of the things that’s most important about it... we’re all very familiar with the rationale with globally diversified portfolios and the rationale to own equities in a global sense. But it also extends to fixed income because it not only offers those important asset allocation components through global diversification, added sources of income, and that important shock absorber with things go bump in the night as it relates to the risk-on investments. So, part of what I want to try to do is to start us off and walk you through some of the lay of the land, kind of walk along with me here and we got two graphs here. The first, on the upper left-hand corner, is a pie graph. The organization is known as SIFMA. It’s a bit of a mouthful but it represents the Securities Industries and Financial Market Association. And what they do is they kind of take stock of the total outsize outstanding landscape of both equity and fixed income. And this represents the total debt stock that’s outstanding as of 2019. The reports usually come in about the third quarter of every year. So, at this particular point, we’re just a hair under a hundred and six trillion dollars. And as you can observe in that pie graph, the United States represents 39% of the total global debt stock. And I think that in itself is a pretty important point to start with. Just if you think about it, most investors who do allocate to fixed income investments, particularly just in the US, they are essentially excluding 60% of the investable universe. Put it more in a way that I think about. We all know the Baskin Robbins 31 Flavors. If you were to only to invest in the US market, you’d be leaving 19 flavors off the table before you even entered the door. So, our job is to try to help bring in the broader set of investment opportunities and continuing, we see that the US, again is 39%, Europe is 21%. That represents 60% of the global stock. But what I find most fascinating and more interesting is the emerging markets. We see it at 16% and then other DM at 6%. Emerging markets and other developed markets have really grown in the last few years. In fact, emerging markets just exceeding 10% of total global debt stock just in the last five years. And it paints a bit of a picture of the lay of the land but one of the things that I find interesting is that as we’re looking as to what the future looks like, is looking at an IMF [International Monetary Fund] kind of ranking of GDP [Gross Domestic Product] of countries by purchasing power parity. We find, in 2016, compared to a study that Price Waterhouse did, is to what the world might look like in the ranking of global GDP. In 2016 we can see that China ranks first on a per-person purchasing power, followed by the US, India, Japan, and Germany. And just looking at the top 5 in the forward right. And again, we know that this is a forecast. And forecasts are subject to a variety of assumptions and so forth. In going with this, and I’ll help give a little context, China is ranked first, followed by India, US, Indonesia, and Brazil. What I find fascinating is only one developed economy is positioned or anticipated to be among the top 5. And this, in part, really does make a bit of sense. Emerging markets represents, of the worlds aggregate of total GDP, emerging markets represents now 59% and is expected to be 70% by 2030. So, in less than ten years it’s going to represent two thirds of the global GDP pond. And additionally, 85% of the world’s population lives outside of Europe and North America and that in itself really highlights the economic growth as well as population trends and overall, essentially consumption and raising the standard of living. And in part, that makes a lot of sense, and we should probably see along that, coinciding, growing of emerging market debt and other developed market debt. And as we go to the next slide, what we’re doing here is trying to explain and give you a little bit of an overview... and it’s a busy slide. I’ll kind of break this down. But step beyond just sort of the lay of the land and what the lay of the land and the future may look like, here we are trying to think, “Okay, what is the investment return characteristics?” And here I’ve captured 29 different benchmarks. And here we break it into four quadrants. And really the message here is that we are trying to capture the risk and return attributes over a twelve-year horizon. The reason I picked twelve years is really that’s when most of the Emerging Market benchmarks started being formalized. And there are four quadrants. And really, our objectives are—in the true spirit of investors—is to essentially provide lower risk with a higher return. But as we start with the quadrants. In the upper northeast quadrant, we can see that the first quadrant is higher-risk, higher return, followed by the lower-risk, lower return quadrant, and as we continue, lower risk, lower return, and then the very top, northwest quadrant, you’re going to find higher-risk, low returns, and that’s a segment that we really kind of want to avoid. Our goal is to target and focus on lower-risk and higher return. On the subsequent slide, we’ve circled a few that we know that have a lot more commonality or a little familiarity and walking through this, in the high-risk, high return area we can see the S&P 500 index. And over a 12-year period, the annualized return is around 15% as well as its standard deviation, about 15%. The MSCI ACWI which is the MSCI All World, is emerging market equities, and we can see that it has a higher degree of volatility with a little less rate of return when compared to the S&P 500. And that, in part, makes some sense. Now, if we were to kind of jump and hopscotch all the way down to the bottom where we see US T-bills under the low-risk, low return... that in itself makes sense because essentially, people own T-bills for the simple purpose of capital preservation and liquidity. But where I’m creeping toward is lower-risk, higher return. It’s interesting to point out that the majority of these particular holdings, such as the circled in there... JP Morgan EMBI, which stands for the JP Morgan Emerging Market Bond Index. Along with an aggregate of other emerging market as well as US fixed income asset classes. And what it points to, and I’ll show on the next slide is really, the risk-adjusted returns of global fixed income as well as US fixed income, offers a very compelling argument from an investment standpoint. And again, there’s a lot of data and a lot of dissecting that I was going through. Let me walk you through the highlights here. So, what I’ve done is measuring the Sharpe ratio which is a measure of the risk-adjusted return. William Sharpe heralds himself from the northwest where he obtained his graduate degree at the University of Washington, and he submitted his first paper under the concept of the Sharpe ratio in 1962. It was rejected as not having a particular value. But in 1990, his work actually was identified, and he was recognized with his Nobel Prize for Economics for his work in helping investors discern and measure risk-adjusted returns or basically providing information. What it does is that you’re looking for securities or benchmarks that are higher relative... meaning the higher the number, the higher the risk-adjusted return. If it’s lower, you’re essentially getting more risk for that particular investment volatility. So, walking through this, on the far-left column, you’ll see the asset classes followed by the ranks in each of the security benchmark classes. And then you’ll see a 12-year, 10-year, 5-year, and 3-year. And under the 12-year scenario, you’ll see a ranking with green being the absolute highest, what’s known as the Bloomberg GCC Credit Total Return. And that’s essentially bonds that originate out of North Africa and the Middle East. Followed by US High Yield at 1.27, US Investment Grade at 1.26, and then a variety of other global fixed income. What I find particularly fascinating: among the top ten, there’s only one equity class and that’s right under that bar. The S&P 500, earning 10th rank. And what you can also observe, and it’s not sorted out because it’s sorted by the 12-year from high to low, there’s a bit of a congruency among the 10-year and the 5-year and the 3-year for each of those global bond benchmarks. That sort of ranking, the top third kind of tends to hold while the middle third and the bottom third kind of... there’s some migration. But by and large you’ll find that there’s some sort of stickiness to that. In Elizabeth and my job, in our work, is we essentially can focus and allocate the Sustainable Bond Fund and global fixed income, among any of the investment securities of those top 9 ranked securities. Really, the takeaway from here is that global fixed income really does, as well as US fixed income, offers a favorable risk-adjusted return argument that really does merit consideration in a diversified portfolio. And now I’ll pass this off on to Elizabeth who will talk a little bit about our investment process.
Elizabeth Alm: Thank you very much. Patrick spoke very well about how global bonds serve as a great diversifier in addition to overall portfolio allocation. Generally specifying “global bonds” isn’t enough. It’s essential as portfolio managers that we choose investments within this asset class and overlay ESG integration. It’s really a key part of this process. You know, through our work we have really observed multiple global bond funds that have very large allocations to Chinese government issuers or unstable economies such as Venezuela, so out of all of the flavors that are open to us in the global bond fund, our job is also to pick the best ones that are going to add the most value for our clients’ portfolio. And this slide is sort of detailing where we are in the ESG market currently. You see a lot of news about the exponential growth of ESG-linked issuance. The chart over on the right-hand side of this slide really looks at green, social, and sustainable issuance through the years and it’s exciting that it has reached about $500 billion in 2020 and is expected to grow exponentially in the coming years. But going back to the first slide where Patrick mentioned the overall size of the bond market at $105 trillion, the pie chart on the left-hand side of this slide shows that these ESG-linked issuance only represent about 1% of the total bond market. So, because label issuance is so small, we really need to go outside of green bonds or social bonds to construct a portfolio. And not only that, to find good value and exciting new opportunities. And as part of that, it’s very important to have a very strong internal process for ESG integration. This graph details our process, and essential to this process, right in the middle, is capital preservation and current income. However, ESG is integrated, you know, very seamlessly into our fixed income security selection. Up at the top of the chart, as with any bond manager, credit fundamentals are key. We’re looking at balance sheet, financial resiliency, and of course governance, but unlike in an equity portfolio, going on to the right-hand side of this chart, you know, we also have technical fixed income considerations that we need to incorporate. This includes current positioning, you know, what maturities do we want to buy, coupon structure, relative value, you know, which securities are we choosing relative to others? And in the case of a global bond fund, we have to consider currency as well. And the next two components of our process are related to ESG, and I’ll go into more detail about that on the next slide, but we are very carefully looking at risks related to ESG. So, climate change, carbon risk, you know, we’re looking at regulatory or transitional risks and anything that could impact the credit or future value of a bond holding. But we are not only using exclusionary tactics, moving on to the very left-hand side of the chart. We are also looking at opportunities within the ESG space and we think this is a very important component to ESG integration overall. So, we are looking at contributions to the Sustainable Development Goals, resource efficiency, obviously business ethics and diversity, but also, you know, what sectors are these holdings in and, you know, can they maybe lend to green infrastructure and just the energy transition alone is going to create a lot of potential opportunities in the future. And this slide kind of goes into detail about how we look at ESG and what’s important to us. You know, if you want more detail, we have a full Impact Report, which we report our holdings within the framework of the UN Sustainable Development Goals and we have also done a previous webinar specifically on these impacts. But, you know, for, you know, the context of global bonds, I’m going to point out some of the important attributes that we look at. Starting on the right-hand side of the slide, upper right, one very important component, of course, is looking at carbon risk and climate change. So, in terms of a global context, really, you know, what are the physical assets? Where are the physical assets? Business sector, contribution to or mitigation against climate change, and this chart details how our Sustainable Funds measure up in regard to carbon intensity versus the MSCI All World benchmark. And carbon intensity really measures the amount of emissions relative to sales and we are very proud that our funds have 72% and 75% less carbon intensity than the index. It really shows that this is a tremendous focus of ours. And one other, moving down in this slide, it’s not enough that a company has a good marketing budget, maybe a good website, and a lot of money to put toward looking good in ESG. We’re also trying to sort out the companies that truly incorporate ESG into their corporate strategy relative to just using it as marketing. And one of the ways that we can do that is look for companies that actually set targets for, you know, in this case, we’re reporting on who’s set at least one quantitative target for a UN Sustainable Development Goal and then makes progress towards those targets. This is, we’ve found, a really good way to see which companies are good actors. And one of the, you know, we report on several Sustainable Development Goals, but the one I am going to focus on today is, I think, one that really encapsulates the focus on where the opportunities are in the bond space related to ESG. And that is specifically SDG 5, which is Gender Diversity. And so, the steps that we report on and that we look at really are supported by research. In this case, we are looking at the percentage and number of women on boards, which a lot of research papers have shown, really does correlate to better corporate profitability and even a better stock price. So, we’re very excited that both the Sustainable Bond Fund and Equity Fund have significantly more holdings with three or more women on the board relative to the MSCI Index. 78% versus 37%. As well as when looking at the same stats from a percentage point of view, 63% have 33% or more on the board for the Sustainable Bond Fund relative to only 20% for the MSCI All World Index. But data is always, you know, an issue in the ESG space, so we also go one step further and we create our own data and do our own research. And that moves us to the very bottom left-hand portion of the chart where we are actually looking through every single holding and we are looking at their sustainability or CSR reports and seeing who, specifically, reports on and mentions each SDG that we report on. In this case, this is looking at who reports in what sector on SDG 5, Gender Diversity. But, you know, the exciting thing about managing a global bond fund is that we are not just constrained to opportunities within the US and with every SDG, we like to give a case study or a story about, you know, exciting opportunities that we are able to invest in. And this December, we were able to purchase the first women’s leadership bond for the Sustainable Bond Fund and basically, this bond has been used to give loans to organizations and enterprises that specifically enhance women’s empowerment and women’s economic advancement. And this includes eight loans to some microfinance organizations as well as direct loans to women-owned enterprises in India, Indonesia, Cambodia, and the Philippines. So, it’s very exciting to be on the cutting edge of the sustainable space and really, to be able to do that, we really need to run and to look globally.
Craig Churman: If you look at the MSCI All World Index, year over year from 2019 to 2020, it actually dropped in terms of the number of women on the board, whereas an active manager, where you and Patrick are putting the strategy together, you can be very intentional about which holdings we will have and making sure that it aligns with how we manage the Fund, but what our clients are looking for. And it really lines up with SDG 5 where a passive strategy or an index strategy, you can’t control the result there...
Elizabeth Alm: Absolutely.
Craig Churman: ...given how much changes in the index. So, I’ll bring Gus back in. Gus, are there any other questions that you’re getting from the field that maybe you want to share with either Patrick or Elizabeth.
Gus Grefthen: Sure, sure, yeah thanks. There was one question, I think, that’s worth of bringing up here. You know, as portfolio managers, how are you guys navigating this low interest rate environment?
Patrick Drum: I’ll start with that if that’s fine. And certainly, defer to Elizabeth if she has comments. So, we have a big playing field. We’re not, you know... We don’t just have to run to first base or second base. We have the entire field to look at. And it also, we spend a lot of hours during non-market hours trying to find and track the market. But it also has a lot to do with structuring in issuance. You know, we are certainly hitting a low interest rate environment and though we’ve seen quite a bit of pronounce uptick in the US 10-year, overall historic 40-year lows. And it has a lot to do with structure and diversification. I mean, right now, we’re still finding great opportunities both in the United States, or investment grade, high quality. Some are floaters, some are step-up, particular issues. But on a global standpoint, we do have exposures to, for example, Mexico and Brazil. A little caveat, a little bit of an important aspect on that... I mean, you are able to get at least 300 basis points in excess of what you’re seeing in the US treasury curve. But to mitigate some of the credit concerns of these regions is we own, actually, supernational bank issuers such as KfW or the world bank IFC. The International Finance Corporation. They provide lending to direct businesses in that region. So, you essentially get a AAA credit, in fact two of the loans are... two of the bonds are... one of the bonds, excuse me, is a green bond, and the other one is not, but they provide funding in that particular region with a AAA credit, with that particular yield enhancement of that region and currency exposure. So, it does provide us these opportunities to allocate the portfolio with differing levels of exposures, of return, duration... I really kind of put it as an analogy of a quilt. And our job is trying to kind of construct and environment that’s going to provide that priority of capital preservation, current income, diversification, and most importantly when things to bump in the night, you can look to it as providing that safety. And we stitch this through by allocating different segments of the portfolio, both with floaters, with some international exposures, some US exposures, and then one in particular that Elizabeth was highlighting, this new impact note in particular that we have exposed to Asia. That in itself is offering just slightly under a 4% yield for us, in 4 years. So, we try to allocate the portfolio in a manner that has that resiliency but these expressions that we are trying to find through the integration of environmental, social, and governance factors to drive performance and more importantly, the investment objective of capital preservation.
Craig Churman: The strategy you run can be 40—it’s a global strategy—40% limitation in any one country, so we can invest in the US, and I think that’s one of the things we want to make sure that we’re saying. It’s a global strategy with an ability to have an impact both outside the US and inside the US.
Patrick Drum: Absolutely.
Craig Churman: And the next... You know, this webinar was on global bonds for achieving impact and diversification but really, it’s going to be a two-part discussion because the next webinar we are going to do is on the equity side. Because we are seeing the same opportunities, particular in the equity side, in some of the developing markets, and we use the, you know, the next webinar to really go a little deeper on the equity opportunities in the emerging markets and in the developing world and where Saturna is finding opportunities there. So, if we have no more questions from the audience, we thank everybody for the time. Thank you, Elizabeth. Thank you, Patrick. As always, your insights are welcome and well worth it and I know the team works very hard to both protect capital but to generate income for our clients. You make a strong case for where global bonds fit in. Thank you very much. Gus is available for any calls you might have. We will welcome a chance to send the slides out. And if you need a copy and a walk through of our Impact Report, we’re available to do that. So, thanks everybody very much. That’s the end of our time and we appreciate you joining the Saturna Sustainable webinar series. Thank you.
Gus Grefthen: Thank you.
Patrick Drum: Thank you for joining.
Elizabeth Alm: Thank you.
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