Big Macs and currencies

Chas Craig, BridgeTower Media Newswires

“A good idea will keep you awake during the morning, but a great idea will keep you awake during the night.”
— Marilyn vos Savant

Despite the importance of fixed income exposure in a balanced portfolio, to the extent I don’t sleep well, I assure you it’s not because of my bond insights. To state the obvious, interest rates are extraordinarily low. For example, the yield on 10-year Treasury notes is just 1.4%, well below the market’s expectation for inflation over the next decade of 2.5% as expressed through the difference in yield between nominal 10-year Treasury notes and 10-year Treasury Inflation Protected Securities. Real interest rates (i.e., nominal rates less inflation) remain at or near all-time lows. Further, the yield to worst for the ICE BofA US High Yield Index of junk rated corporate bonds sits at 4.8% (up from about 4% pre-omicron variant news), which was not an unusual reading for 10-year Treasury notes in the decade preceding the Financial Crisis.

Given the challenging opportunity set, it seems rational for investors to at least learn about areas that previously weren’t in their fairway. Below I provide a brief investment case for owning a skosh of international corporate bonds in a diversified portfolio.

The Bloomberg Barclays Global Aggregate ex-USD Corporate Bond Index is a measure of global investment grade debt from 24 local currency markets. It is no secret that sovereign bond yields are in negative territory throughout much of the developed world, most prominently in the E.U. and Japan. As a result, the 1% spread over comparable maturity sovereign bonds from the countries in which these corporate bonds were issued is only enough to get the average yield of this index to a whopping 0.5%. How could it be then that this index delivered a U.S. dollar (USD) based return of 12.3% in 2020 (down 8.8% YTD 2021) compared to 9.8% (down 1.3% YTD 2021) for the ICE BofA US Corporate Index, which has maintained a structurally higher quoted interest rate (currently 2.3% for a spread over comparable maturity Treasury securities of 1%) over the two periods?

The biggest differentiating factor is that the U.S. Dollar Index (DXY) weakened (i.e., foreign currencies strengthened) to the low end of its 90-100 normal range over the past seven years against other major world currencies by year-end 2020. Subsequently, DXY has increased to 96.5 as a variety of factors, perhaps the most important of which being expectations for relatively tighter domestic monetary policy, have brought about a bid for the green back.
However, despite the recent strength, the Big Mac Index, which was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level, indicates that the USD is materially overvalued compared to the weighted currency basket underlying the index discussed above. The ubiquitous nature of a McDonald’s Big Mac makes its price in different countries have some utility as a currency valuation tool. The index implies “fair value” for DXY in the low-80s, near the low end of the long-term range dating back to the mid-1960s and consistent with the level at which DXY traded from early-2007 to mid-2014.

Since yields are so low or negative in developed markets ex-U.S., it is easy to dismiss the segment. However, respecting the purchasing power parity argument made by the Big Mac Index, it might be worth the time of bond investors with the flexibility to invest globally to learn more about the space’s characteristics.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).