LDI: How Large an Allocation to Global Bonds?

Liability-driven investors can reap significant benefits from globalizing their long-duration bond portfolios, but how much should they sow? How large an allocation to nondomestic bonds is appropriate? Our research suggests that even a modest allocation can meaningfully improve an LDI portfolio’s risk-adjusted return potential.

As we examined in our previous blog, liability-driven investors have been slow to embrace global investing: traditionally, domestic bonds have been considered the best match for long-term liabilities such as pension obligations. However, an allocation to currency-hedged global bonds can help reduce downside risk while capturing most of the upside return potential of domestic bonds, creating an opportunity to improve a plan’s funded ratio.

The key question for liability-driven investors is how large this allocation to global bonds should be. Three of my colleagues—Alison Martier, Erin Bigley and Ivan Rudolph-Shabinsky—have recently published research that sheds some light on this question. Should liability-driven investors convert their entire fixed-income portfolios to global debt?

Our research suggests that the answer is no. There is generally a close correlation between returns for domestic-only long bonds and hedged global bonds, but the gap between the two can at times be quite large.

Over the past 25 years, the largest outperformance margin for domestic bonds over global bonds was 13.2% for a US dollar–based investor and 9.5% for a euro-based investor. However, the biggest gap for sterling- and yen-based investors was nearly 20%—and in the UK and Japan the correlation between domestic and global bond returns is lower. So where is the sweet spot that allows the liability-driven investor to capture the advantage of going global? To answer this question, we looked at various combinations of domestic and nondomestic bonds, as the display below shows.Finding the Ideal Allocation to Nondomestic Bonds

Adding even 10% to 20% of nondomestic bonds significantly improves the risk-adjusted return potential of a portfolio. The incremental improvement in return/risk ratio from adding more nondomestic exposure generally diminishes after reaching a 50/50 blend, our research suggests.

The appropriate allocation, of course, varies depending on each investor’s risk tolerance and specific home country. For example, a sterling-based investor might find a larger exposure more attractive, whereas a yen-based investor might find a smaller exposure to global bonds appropriate. The key takeaway though, is that in these four regions, liability-driven investors can benefit from an allocation to global debt.

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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