LDI: The Case for Going Global in Bonds

Despite compelling evidence in favor of global diversification, investors in many markets around the world continue to have a strong “home bias”—a preference for domestic over foreign assets. Nowhere is this tendency more apparent than in the ranks of liability-driven investors. But our research shows that LDI investors, too, can reap significant benefits from going global.

On the surface, liability-driven investors’ preference for domestic bonds makes good sense. The primary concern of liability-driven investors, after all, is not maximizing returns, but ensuring adequate funding levels to match long-term liabilities such as pension obligations. The current value of these liabilities is generally sensitive to domestic interest rates—hence the common assumption that the purchase of long-duration domestic bonds is the best way to reduce the risk of funding shortfalls.

But is it possible to improve the investment outcome by going global? Three of my colleagues—Alison Martier, Erin Bigley and Ivan Rudolph-Shabinsky—have recently published research indicating that investors in several of the world’s major markets have historically been able to achieve comparable returns—with significantly lower volatility—by globalizing their long-duration bond portfolios, as the display below shows.Hedged Global Bonds: Historically Less Volatile than Home-Country Bonds

For liability-driven investors, however, absolute returns and volatility are less important than minimizing mismatches between assets and liabilities. For this reason, we looked at the actual pattern of long-dated bond returns. For investors based in the US, Canada, Japan, UK and the euro area, we found that the returns of domestic and currency-hedged global bonds were highly correlated. This suggests that by adding an allocation to global bonds, there is an opportunity to improve the risk/return profile of an LDI portfolio without creating a sizable gap between liabilities and assets.

Importantly, we also found that when the returns of one country were at an extreme—either positive or negative—the global average was less extreme. This shouldn’t come as a surprise, since global returns are the average of several countries, reflecting the benefits of diversification. But it suggests that exposure to global bonds can mitigate the impact of very weak or even negative domestic returns.

And that seems especially relevant today. Given the current market environment—with yields on bonds near historical lows in many developed nations—domestic bond returns are likely to be very low or negative once interest rates eventually begin to rise to more normal levels. Although returns for global bond portfolios are also likely to be weak, history suggests that they may suffer less than domestic-only portfolios, reducing downside risk. Of course, liabilities tend to closely track domestic bond returns, so when domestic yields rise and produce negative returns, liabilities may also decline. But a global bond portfolio could take advantage of this opportunity to improve a plan’s funding ratio by “losing less.”

All told, we think these are compelling reasons for liability-driven investors to consider an allocation to hedged global debt. What should the size of this allocation be? We’ll consider this and other aspects of the use of global bonds for LDI in future posts.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income, Alison Martier and Erin Bigley are Senior Portfolio Managers of Fixed Income, and Ivan Rudolph-Shabinsky is a Portfolio Manager of Global Credit, all at AllianceBernstein.

Douglas J. Peebles

Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer of AB Fixed Income. In this role, he supervises all of the Fixed Income portfolio-management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within the fixed-income division, having served as director of Global Fixed Income from 1997 to 2004, and then co-head of AllianceBernstein Fixed Income from 2004 until August 2008. He earned a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

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2 thoughts on “Are Bonds Really Less Risky than Equities?

  1. Hi Patrick,

    Fascinating study. Thank you for sharing it. I was wondering, when you show real returns of stocks broken down by capital gain and dividend yield, are you subtracting the rate of inflation from the capital gain or from the dividend yield or both? In other words, are you showing nominal yield and real capital gain? Or real yield and nominal capital gain? Or some type of adjustment in between. Thanks again for sharing.

    • The methodology applied by the authors of Triumph of the Optimists: 101 Years of Global Investment Returns is to measure real equity total returns and real equity capital gains. I show the dividend yield as the difference between the two. For example, the real equity total return from 1900 to 1910 was 6.8% annualised; the real equity capital gain was 2.0% and we show the difference between the two of 4.8% as the real yield. Incidentally, the returns to the world equity series comprises a seventeen-country, common-currency (US dollar) index and hence real returns are after US inflation.

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