Ch7. Global Bond Markets — Comparing Treasuries, EM Bonds, and High-Yield

The Size of the Global Bond Market

The bond market is larger than the stock market.

Global Bond Market (as of 2024):
Total size: ~$130 trillion (approximately 1.3× the equity market)

Composition:
Government bonds (developed markets): 45%
Corporate bonds: 25%
Emerging market bonds: 15%
Other: 15%

US Treasuries (UST)

Why US Treasuries Are the Benchmark

The standard for risk-free assets:
- The dollar = the world's reserve currency
- United States = virtually zero default risk
- Liquidity: hundreds of billions traded daily

The spread benchmark for all risk assets:
Corporate bond yield = Treasury yield + credit spread
Emerging market bond yield = Treasury yield + country risk premium

Types of US Treasuries

T-Bills: maturity up to 1 year (short-term)
T-Notes: maturity 2–10 years (medium-term) ★ The 10-year is the most watched benchmark
T-Bonds: maturity 20–30 years (long-term)
TIPS: Treasury Inflation-Protected Securities

The 10-year Treasury yield:
- Benchmark for mortgage rates
- Discount rate for equity valuations
- Directional influence on the strength or weakness of the dollar

Emerging Market Bonds (EM Bonds)

Types

Hard Currency EM Bonds (Dollar-Denominated):
- Issued by emerging-market countries in US dollars
- No currency risk
- Only country default risk to consider
- Representative index: JP Morgan EMBI+

Local Currency EM Bonds:
- Issued in the domestic currency (e.g., Brazilian Real, Indian Rupee)
- Higher interest rates
- Additional currency risk
- Representative index: JP Morgan GBI-EM

Risks of EM Bonds

Country risk: sovereign default (Argentina, Sri Lanka as examples)
Currency risk: EM currency depreciation → reduced returns in home currency terms
Liquidity risk: difficult to sell during crises
Political risk: regime change, policy shifts

Why Invest in EM Bonds?

Higher yields than developed markets:
US 10-year Treasury: ~4% (as of 2024)
India government bonds: ~7%
Brazil government bonds: ~12%
Indonesia: ~6.5%

Note: subtract currency hedging costs to get the real effective spread

High-Yield Bonds

Characteristics of Sub-Investment-Grade Bonds

Credit rating: BB+ or below (below investment grade)
Alias: Junk Bonds

Why the higher yield?
→ Compensation for credit risk (probability of default)
→ Liquidity premium
→ High sensitivity to economic cycles

Historical returns:
2–5 percentage points above investment grade bonds per year
However, default rates spike in recessions, which can cause losses

High-Yield vs Equities

Characteristics of high-yield bonds:
- Fall alongside stocks when equities decline (credit risk = cyclical sensitivity)
- Less volatile than stocks (bonds have a floor value)
- Similar income characteristics to dividend-paying stocks

Conclusion: high-yield bonds sit between bonds and stocks
They do not provide the full defensive qualities of investment-grade bonds

Dollar Strength/Weakness and Global Bonds

Dollar strength environment:
→ Unfavorable for EM bonds (higher burden of servicing dollar-denominated debt)
→ Favorable in home-currency terms for dollar-denominated bond holders
→ Losses for investors holding local-currency EM bonds

Dollar weakness environment:
→ Favorable for EM bonds (capital inflows)
→ Maximizes returns on local-currency bonds
→ Rising commodity prices → improvement for commodity-exporting EM countries

How International Investors Can Access Global Bonds

Currency hedge decision:
Hedged: eliminates currency risk, but hedging costs arise (0.5–2% per year)
Unhedged: a bet on the direction of the dollar — potential additional gains or losses

Practical choices:
- Short-term (1–2 years): US short-term Treasuries unhedged (dollar income + conversion)
- Medium-to-long-term: strategically maintain dollar exposure (risk diversification)
- Emerging markets: use global EM bond ETFs for diversification

How to Access Global Bonds

Direct investing (difficult):
- High minimum investment and low accessibility
- Complex tax, currency exchange, and custody arrangements

ETF approach (recommended):
AGG: iShares Core U.S. Aggregate Bond (Treasuries + corporates)
BND: Vanguard Total Bond Market
TLT: iShares 20+ Year Treasury Bond
SHY: iShares 1-3 Year Treasury Bond
EMB: iShares JP Morgan USD Emerging Markets Bond
HYG: iShares iBoxx $ High Yield Corporate Bond

US 10-year Treasury = global risk-free rate benchmark EM bonds: dollar-denominated (no currency risk) vs local-currency (currency risk present) High-yield = junk bonds = cyclically sensitive, higher returns, default risk Dollar strength → unfavorable for EM; dollar weakness → favorable for EM