Back in February 2014 we identified a vulnerable subset of countries that fall in the 1 and 2 star Stratton Street NFA ranking categories and have net foreign liabilities in excess of 50% of GDP. We dubbed the group “Paintbrush”, because it looks much better than “Brtpahsiun” which is how they nations appear on our presentation slides! The nations are Poland, Australia, Indonesia, New Zealand, Turkey, Brazil, Romania, Ukraine, South Africa and Hungary.

Anyway, we thought it would be worthwhile to share with you what an investor gets paid for taking risk on board. The following statistics are taken from our Relative Value Model, which in the case of our US Dollar universe, looks at our universe of bonds and works an average out for a given rating and duration. So for example, the current “fair value” spread of an A2 rated bond with a 5 year duration is 74 basis points over US Treasuries. When we say that a bond is trading 3 notches cheap (+3), in this example it would be trading as if it were rated Baa2 (i.e. 3 rating notches lower), and have a spread closer to 139 bps. Two notches expensive (-2) would imply a Aa3 rating, with a spread closer to 49 bps.

Back to “Paintbrush”. Taken as an average, the group trades close to fair value, i.e. no extra “cushion” in the spread. If we look at all nations rated either 1 or 2 stars (excluding Greece), the numbers dip into negative territory. So not only are the countries poor from an NFA (net foreign asset) perspective, they are also “expensive” to boot!

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Geo Political Risk

Geopolitical risk is frequently cited as a risk investors are, rightly, concerned about. However, geo-political and political risk are two different concepts which are often used interchangeably, despite their very different meaning. So let’s first look at political risk. 

Political risk is a measure of the impact of political tensions on the domestic economy. For example, concerns that a UK general election which caused a change of government in the UK from Conservative to Labour might lead to the perception of increased political risk (or reduced, depending on your political leaning). Rating agencies take account of political risk when assigning credit ratings, so you would not, normally, expect to need to add a risk premium for a country with higher than average political risk. 

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Global Growth Model

Global Growth Model

Stratton Street’s disciplined investment process incorporates both top down and bottom up elements when constructing our portfolios. We understand the importance of macro positioning across a market cycle to ensure consistent performance. Whilst our credit selection process ultimately determines the underlying positions within the portfolio, we utilise a number of proprietary models to ensure we are well positioned from both a duration and credit risk perspective. Macro positioning is an essential for effective management of credit portfolios - and we are active in rotating our macro positioning to fit.

One of our primary models that we have been using since 1997 is the Stratton Street Global Growth Model (“GGM”) - this is a proprietary model that utilises three economic indicators:

- German IFO2
- Japanese inventory to shipments ratio

The data points above are widely available and we use simple regression analysis to determine the weighting to each factor. More importantly, the factors incorporated within our GGM are typically available ahead of OECD Industrial Production (“IP”)3 data by ~6 months, providing us with a leading indicator of where we are in a global macro cycle.

This information can be invaluable to credit managers - by understanding where we are within a global macro cycle we can determine how much credit risk we want to take. For example we know that weak global growth is supportive of high grade bond markets; whilst in an expansionary phase lower grade credits outperform.

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What does duration tell you about bond risk? Not as much as you thought!

Duration. It’s a short word, with a simple meaning, but those eight letters cause more confusion in the minds of many investors than almost anything else. In fact, there are many variants of duration: spread duration, Macaulay duration, modified duration, but the most frequently used is the latter, shortened to simply “duration”.

So what does duration mean?

The first point to realise is that duration is not the same as maturity. Furthermore, duration does not increase linearly with maturity, so the duration of a 30-year bond IS NOT three times that of a 10-year bond. The only exception to this is for zero coupon bonds where duration and maturity are the same. Currently the duration of the US 10-year is 8.81 years and the duration of the 30-year is 19.51 years.

Although linked, the different types of duration all have subtly different meanings. For example, Macaulay duration is the weighted average number of years an investor must hold a bond until the present value of the bond's cash flows equals the amount paid for the bond. This is useful for bond managers managing long term liabilities, but it has limited practical use for most investors.

On the other hand, modified duration is useful for both bond managers and investors as this version of duration measures a bond’s sensitivity to changes in interest rates. So, for instance, a bond with a duration of three years will gain or lose 3% if interest rates fall or rise by 1%. That’s just an approximation though, and strictly speaking the duration concept only works for small changes in interest rates. This note is not intended to be overly technical though, so for our purposes we will assume that a bond with a three-year duration will gain or lose 3% for a 1% change in interest rates.

Where confusion tends to creep in, is the assumption that the change in interest rates refers to a change in short term interest rates. When the press refers to interest rates having risen by 0.25 or 0.5 percent, they are almost certainly referring to the Fed Funds rate in the US or the equivalent base rate in other countries. Very rarely do the words interest rates refer to longer dated bonds in the media. In reality, there are a wide range of interest rates which apply to bonds of maturities up to 30 years or more, but to avoid confusion, in this note we will use interest rates or short rates to refer to short term rates and bond yields for longer dated bonds.

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Renminbi Outlook 2016 and Beyond

This short paper outlines the factors that have contributed to the Chinese renminbi’s strength over the past decade. The analysis highlights how these conditions largely persist and require prolonged periods to unwind during which they will continue to exert long-term upward pressure on the currency:

  • China’s large positive net foreign assets position remains an important driver for longer term currency appreciation.
  • Renminbi undervaluation in PPP terms should lessen with China’s relatively faster growth and  rising incomes.
  • PBoC latest goals for high-skilled manufacturing, services and increased domestic consumption are inconsistent with a weakening exchange rate.
  • Weaker global growth points to a softer dollar and relatively stronger renminbi according to its managed FX basket weightings.
  • Significant but often overlooked renminbi interest rate carry cushion provides additional potential return alongside any appreciation.

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Stratton Street Investment Philosophy

For more than 30 years, a combination of receding inflation and increasing leverage has created an extraordinary bull market for bonds that now is coming to a close. Traditional fixed income investors can no longer expect a rising tide of new issuance, low inflation and strong economic growth to keep debtors afloat. A new era of fixed income investment is unfolding that will require more active management to find value in an environment of low yields. Central bank intervention raises the dual spectres of illiquid markets and overvalued asset prices as carry trades and central bank purchases distort prices. New metrics are needed not only for identifying value but also for sorting out vulnerable borrowers from those with a high probability of weathering the new environment of low growth and low inflation.

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Renminbi Inclusion in SDR basket

On the 8th anniversary of the original Renminbi Bond Fund ("RBF"), the Chinese renminbi should finally receive the official global reserve status we have been patiently anticipating.

The number 8 in Chinese culture represents luck, fortune as well as “strong intuition and insight”. For us therefore it seems particularly fortuitous that Monday’s anticipated inclusion of the renminbi into the SDR arrives the same day as the 8th anniversary of our Renminbi Bond Fund.

Launched in 2007, before any other fund of its kind and well before the launch of the Dim Sum market itself, RBF aimed to create a sensible high grade asian bond product with exposure to the appreciation of the Chinese renminbi. The latter on the premise that this highly competitive superpower - accounting for their large reserves, current account and trade surpluses, inflationary pressures and welfare/prosperity aspirations - would pursue a lofty ambition of equal global reserve status with the US dollar.

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Special Report: PBoC Fixing Policy

  • The renminbi depreciation was the natural result of the significant shift in PBoC policy to adjust the renminbi fixing in line with the previous close effectively freeing the currency to market forces yet retaining its ability to avoid shocks from when markets are “distorted”.
  • August 13 PBoC statement strongly confirms that the underlying rationale is not to promote exports but for meeting internationalisation requirements and aspirations to be included in the IMF’s SDR this year. (link: PBoC Statement 13 August 2015)
  • The renminbi is already at a comfortable level for the PBoC and a long term path of appreciation is still expected.
  • Longer term comparison of China with the industrialisation of Japan points to the potential scale of further renminbi appreciation over the coming decades even as growth slows.
  • The move has had a strong positive impact on the bond market, especially in higher grade credit and puts further strain on inflation and growth in the west which is broadly negative for stocks and positive for bonds.

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An Anatomy of a Sell Off - Taper Tantrum II

Bond land looks a little saner now that negative yields are disappearing from the Eurozone landscape. Those elevated prices never made any sense for real money investors, most of whom could not or would not buy bonds that would lock in a capital loss. That certainly is the hard reality for German insurance companies which collectively hold more German debt than any other institutions. Only hedge funds and trading desks that could leverage a carry trade at zero funding cost would bet that the carry would be worth the risk of capital loss. The ‘greater fool’ in this episode had to be the ECB whose belated and oversized asset purchase plans fomented this bond buying folly in the first place. Now bond prices have gone full circle back roughly to where they were prior to the buying frenzy in anticipation of the onset of the PSPP (ECB Euro-system public sector purchase program) in March.

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Déjà vu Deleveraging

  • When oil prices were above $100/barrel (such as 2011 to early 2014) oil companies and their suppliers were the preferred leveraged equity trade
  • Similarly, EM currencies and high yield bonds were the preferred carry trades under zero interest rates policies (ZIRP) and quantitative easing (QE)
  • Oil prices have fallen by more than 40% during 2H 2014. This could have serious implications for vulnerable debt issuers with unsustainable debt levels
  • European corporate debt spreads have held up remarkably well during the sell-off in recent months – likely driven by expectations of monetary policy in the eurozone during Q1, 2015
  • 9 out of 15 of the world’s largest debtors relative to GDP are located within the eurozone
  • The FOMC press release on 17 December included the word ‘patient’ – the first rate hike is therefore likely in April 2015
  • Financial markets already reflect the first rate hike – few bonds with maturities less than 3 years have value (with the exception of Chinese sovereign and quasi-sovereign debt)
  • China’s quest for reserve currency status in 2015 will attract considerable attention. Both equities and the CNY will continue to benefit from lower oil prices

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China's Gordian Policy Knot

  • The renminbi will appreciate 2-3-% per year on average over the next five years. A stronger currency is the only way to limit the high cost of forex sterilization.
  • The PBOC will widen the currency bands whenever hot money flows reappear until they are +/- 5%.
  • The principal drivers of the currency will be China’s current account surplus and China’s status as one of the world’s largest creditors.
  • Greater renminbi flexibility will be accompanied by continued strides to develop local debt instruments.  
  • In contrast with other interest rates, deposit rates will not be deregulated anytime soon.
  • The ongoing internationalization of the renminbi should be viewed as means for lowering the cost of trade transactions rather than a driver of the currency per se.
  • The final phase of China’s financial evolution will lead to substantial overvaluation by as much as 25% to 30%.
  • Complete convertibility including financial flows will be among the last of the financial reforms.

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Does lending to debtors make sense for bond investors

A whole branch of theory of efficient markets has argued that it is efficient to allocate your
money based on the amount of securities outstanding. The more debt a country has, the more
weight they get in the index. As we have seen with Greece, this can lead to an unsustainable
spiral of debt, followed by a sudden default. This paper examines whether net foreign assets, a
measure of a country’s net wealth, can reliably predict future defaults and concludes that
allocating to countries with net wealth, rather than net debt, leads to superior returns for fixed
income investors.


Bond indices are constructed using the amount of securities outstanding and therefore gives a
disproportionately high weight to the most indebted companies and countries. As countries and
companies become more indebted, their weight in these indices tends to rise. Left unchecked,
this would result in significant defaults in portfolios of bond investors who track indices
closely. However, this effect ought to be mitigated if rating agencies were to downgrade
countries well in advance of default, giving investors time to adjust their portfolios accordingly.
However, the example of Greece illustrates that rating agencies have been slow to adjust
ratings as economic fundamentals deteriorate. In early 2009, Greece was rated A1 by Moody’s
and A- by Standard & Poor’s. Based on a long series of historical data, such a rating implies a
probability of default of considerably less than one percent within three years.

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