By Alison Martier and Seth J. Masters
Many US defined contribution (DC) plan sponsors are seeking solutions aimed at reducing undue volatility—excess volatility without a commensurate increase in return—that can prevent a plan and its participants from achieving their long-term objectives. Our research suggests that hedged global bonds may be one solution.
Global Bonds Meet the “Core” Objective
We consider our investment services and solutions in terms of meeting an investor’s objectives. The stability objective appears at the lower left of our fixed-income risk-return spectrum. At the other end of the spectrum is high income. Typically, higher income comes from lower-quality securities, such as high-yield bonds. These volatile sectors have a relatively high correlation with equities and other risk assets.
Between the stability objective and the high-income objective lies the core objective. Core assets are those that tend to perform substantially better when the value of risk assets declines.
When market volatility is high, and equities and high yield are exhibiting a lot of volatility and performing poorly, investors want to have an anchor in their portfolio that has the potential to mitigate risk assets’ poor returns. That “anchor to windward” is core.
Most US plan sponsors have opted for a US core or US core-plus portfolio as the core option in their DC plan. However, some have begun to adopt global fixed income. These sponsors already understand the potential benefits we outlined in last week’s post.
Unfortunately, what we’ve observed is that many adopters of global fixed income have been subjected to a lot more volatility than they anticipated. Their objective remained core, but their volatility increased, putting them into the risk-assets category, along with investors seeking high income.
How could that be?
The error comes in buying global bonds that aren’t hedged. As explained here and here (as well as in our white paper), currencies are significantly more volatile than bonds. As a result, an unhedged global bond approach fails to fulfill the core objective. Remember, core assets must exhibit low volatility in order to serve as anchor to windward.
However, once the currency risk is hedged, the overall risk of the global bond portfolio declines sharply, without sacrificing return, putting hedged global bonds squarely in the core column (display).
Hedged Global Bonds: Comparable Return, Less Risk
When we compare the three-year rolling standard deviation of both global bond approaches—hedged and unhedged—as well as US core bonds over the past 20 years, the unhedged global approach (represented by the Barclays Global Aggregate Index unhedged) has been by far the most volatile series. US bonds (represented by the Barclays US Aggregate Index) have been much less volatile.
But—drum roll, please—the hedged global approach (represented by the Barclays Global Aggregate hedged to the US dollar) has had the lowest volatility of the three series.
Does this lower volatility translate into lower returns?
No. Our analysis examined annualized returns over the same long period we’d used for historical volatility, to see just how well the three approaches—global unhedged, US and global hedged—stacked up (display).
All three fared about the same in terms of raw annualized returns.
But the risk-adjusted returns tell the full picture. The Sharpe ratio, which measures return per unit of risk, climbs from global unhedged at 0.6 to US at 0.9 to global hedged at 1.0.
Hedged global bonds, in risk-adjusted-return terms, come out the clear winner in the historical data. Global hedged is simply a better way to meet the core objective.
With the results of this analysis in hand, we’ll discuss in future posts adding global to DC plans, both as a core option and as a component of the default option such as a target-date fund.
“Target date” in a fund’s name refers to the approximate year when a participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as participants near retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested—including at the time of the fund’s target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.
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.
Alison Martier is Senior Portfolio Manager—Fixed Income at AllianceBernstein, and Seth J. Masters is Chief Investment Officer of Defined Contribution Investments and Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.