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Foreign Bonds Still No Bargain

By Benjamin Shepherd on September 17, 2015

While Pacific Digest focuses on stocks, bonds also play a role in any well rounded portfolio. If you talk to any investment professional and they tell you to totally avoid bonds or that you just don’t need them, you should probably find someone else.

That said, global bonds have had a rough year. Over the past 12 months, local currency emerging market bonds have been particularly big losers with a loss of more than 21%. German bonds, which are priced in euros, are down by nearly 10% over the past year in U.S. dollar terms. Most bonds priced in local Asian currencies are down by 13% or more, which most Aussie issues are down by about 20%. Most all of that is thanks to the stronger U.S. dollar.

The dollar has dipped a bit on the news that the U.S. Federal Reserve has decided to stand pat on interest rates, so international bonds have gained some ground. Euro bonds are doing particularly well thanks to the weaker dollar and the European Central Bank’s own stimulus efforts. Don’t be tempted though, this dollar dip is likely to be short-lived.

The simple fact is, international bonds have been bid up to near-historic levels as American investors have been forced to look abroad to find favorable yields. Even with the sell-off over the past year, most global bonds are still pretty richly valued, especially when you consider the added risk they carry. On top of that, a rate hike in the December meeting isn’t off the table.

In its statement released after the meeting, the Fed said, “Recent global economic and financial developments may restrain economic activity somewhat,” but it didn’t go so far as to take a December increase off the table. As it stands, the CME FedWatch, which uses 30-day fed funds future prices to calculate the odds of a rate increase, still predicts a 50% chance of a bump up in December. The odds rise to 60% for the January meeting.

Of course, that’s not a guarantee of action and, frankly, I’m somewhat surprised the Fed didn’t act this time around. While global economic growth still faces some headwinds, data here in the U.S. is still generally positive, especially on the employment front.

Employment statistics are closely watched by the Fed since a tight labor market can drive inflation; when unemployment is labor, workers have more bargaining power over wages. Applications for unemployment benefits have been below 300,000 for the past six months, something which hasn’t happened since 1973, while the unemployment rate is at 5.1%. If American businesses are confident enough to continue hiring, they clearly aren’t expecting the recent turbulence to turn into much else.

So while the Fed choose to keep its powder dry at this meeting, a bump in interest rates is by no means off the table so the dollar isn’t likely to enter a period of sustained weakness. That means the rout in global bonds is far from over, so even though their yields are now even higher, they’re likely in for more turbulence.

Stocks, on the other hand, are a different story. While local market shares have lost value in dollar terms, companies which do quite a bit of international business – particularly in the U.S. – will get a boost. It’s always a good deal when you can sell your products in U.S. dollars, then convert those dollars into weaker currencies, getting more bang for their buck. So while foreign bonds aren’t a good deal at this point, stocks still are.

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