Managing global-bond funds has become much more difficult because the overseas government debt market is awash with roughly $13 trillion in bonds offering negative yields. Japanese government bonds, represent the vast majority of this debt, more than four times as much coming from France or Germany, which have issued the next-largest amounts.
Japan's currency climbed by 23% versus the U.S. dollar in 2008
Given Japan's prominence in global bond indices, making up 20% to 35% of overall exposure, yields on those benchmarks have been feeling the crunch since the two-year Japanese government bond dipped into negative territory in December 2014, and this year, 10- and 20-year Japanese government bond yields slid below zero.
In Europe, negative-yielding debt has become more prominent as well: two-, five-, and 10-year German bunds and Swiss government bonds across the maturity spectrum sport negative yields, for example.
Japanese bonds may seem a necessary evil for world-bond fund managers, especially those that need to align a fund's risk/return profile with that of the benchmark. But Japanese government bonds can still be a useful tool. Many managers use Japanese government bonds to some extent to balance a portfolio's higher credit risks, and the yen has historically provided ballast in times of market stress.
Japan's currency climbed by 23% versus the U.S. dollar in 2008, and it also strengthened versus the dollar during the third quarters of 2011 and 2015 when emerging-markets currencies sold off. Negative-yielding Japanese government bonds can still generate capital gains by rolling down the yield curve as the bond nears maturity, which would cause its yield to fall further if the yield curve maintains its current shape. Japanese government bonds can also realise gains if Japanese interest rates slip deeper into negative territory. However, there is the risk that if rates fall too far, the negative yield would wipe out any potential capital gains.
Another reason to avoid Japanese government debt is the risk of interest rates nudging upward, which could have a significant impact on a low-yielding portfolio. So even if Japanese government bonds have diversification potential, there is risk in choosing a world-bond index fund or exchange-traded fund over an actively managed option that has already reduced that exposure or can tactically manage it.
Investors in Vanguard Total International Bond Index ETF (BNDX) and similar passive options have more than 20% in Japanese government bonds, not to mention other negative-yielding European debt.
