Common assumptions about the best way to hedge liabilities may be blinding investors to potentially better strategies.

Alison Martier, CFA Senior Portfolio ManagerFixed Income Ivan Rudolph-Shabinsky, CFA Portfolio ManagerCredit Erin Bigley, CFA Senior Portfolio ManagerFixed Income

LDI: Reducing Downside Risk with Global Bonds

Our research shows that for many investorsparticularly those seeking assets to match long-term liabilitiesadding exposure to hedged global bonds can improve the risk/return profile of their portfolio versus a domestic-only bond portfolio.
Revisiting Basic Assumptions
Many institutional investors have recognized the benefits of a global approach to investing, but this approach hasnt gained as much traction in liability-driven investing (LDI). Investors using LDI are, by definition, more interested in immunizing their liabilities than in maximizing total returns, and there is a widespread assumption that long-maturity domestic bonds are the best and safest match for long-term domestic liabilities such as pension obligations. On the face of it, this home-country bias seems entirely logical. Pension liabilities can be thought of as long-dated cash flows, and the present value of these cash flows is typically calculated
Display 1

using domestic long-term interest rates. So changes in domestic interest rates largely drive the current value of liabilitiesjust as they drive the current value of long-term bonds. But while investing in long-term domestic bonds provides a simple way to immunize future liabilities from an accounting standpoint, is there a way to improve potential outcomes by diversifying globally?

Hedged Long-Term Global Bond Portfolios

Annualized Returns and Volatility: October 1987December 2011
10 Percent Annualized Return Annualized Volatility

Return/Risk Ratio 1.1

US Hedged Global (USD) 1.3

Euro Hedged Area Global (EUR) 1.1 1.4

Japan Hedged Global (JPY) 0.8 0.9

UK Hedged Global (GBP) 1.2 1.6

Global bond portfolios represented by the Citigroup World Government Bond Index (WGBI) 10+ through December 1998 and the Barclays Capital Global Government/Credit Index (GGCI) 10+ from January 1999 through December 2011; domestic bond portfolios represented by each markets bonds within the Citigroup WGBI 10+ and the Barclays Capital GGCI 10+. Prior to 1999, the euro area is represented by Germany, with returns hedged to a basket of European currencies. Source: Barclays Capital, Citigroup and AllianceBernstein

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Hedged Global Returns Highly Correlated with Domestic Returns

In the major markets that we examined, long-term, annualized, currency-hedged returns for long-maturity global debt bonds with terms of 10 years or longerhave been close to the returns for domestic long-maturity bonds.1 In the UK and the euro area, a hedged global portfolio would have actually outperformed domestic bonds. And in each of the four major markets, volatility has been lower and the return/risk ratio higher (Display 1, previous page). It is important to note that our analysis utilizes global bonds that are fully hedged back to domestic currencies. Currency returns tend to be significantly more volatile than bond returns. For example, while the annualized volatility of longterm global bonds hedged to US dollars was 6.6% over the period we studied, as shown in Display 1, if the currency was left unhedged, the volatility of those global bonds would have been 8.8%. However, for liability-driven investors, absolute returns and volatility matter less than minimizing the mismatch between liabilities and assets, so we looked closely at the actual pattern of returns. The green lines in Display 2 show rolling 12-month returns for long-maturity bonds in the US, the UK, the euro area and Japan. The blue lines show the returns for a portfolio of long-maturity global bonds, hedged into the US dollar, sterling, euro and yen, respectively. These hedged returns are highly correlated with domestic bond returns for US-, UK- and euro-area-based investors, suggesting an opportunity to
1

Display 2

Hedged Global Bonds Closely Track Domestic Bonds

Local Bonds vs. Hedged Global Bonds: Rolling 12-Month Returns
Local Hedged Global

60 Percent 40 20 0 (20) 86 91 96

US Percent

40 20 0 (20) 86 91

Euro Area

01 UK

06

11

96

01

06

11

60 Percent 40 20 0 (20) 86 91 96

40 Percent 20 0 -20 88 92 96

Japan

01

06

11

00

04

08 11

US and UK data begin December 31, 1985; euro-area data begin June 30, 1986 and Japan data begin September 30, 1988. Global bond portfolios represented by the Citigroup WGBI 10+ through December 1998 and the Barclays Capital GGCI 10+ from January 1999 through December 2011; domestic bond portfolios represented by each markets bonds within the Citigroup WGBI 10+ and the Barclays Capital GGCI 10+. Source: Barclays Capital, Citigroup and AllianceBernstein

improve the risk/return profile of an LDI portfolio without creating a sizable gap between liabilities and assets.

Pattern of Performance Is Key

Investigating further, we reordered each rolling 12-month return for domestic bonds. Instead of listing them chronologically, we arranged them from lowest return to highest (Display 3). That put the lowest returnslosses of more than 10%on the far left and the highestgains of 20% or more on the far right. Each green dot represents one observation. We then matched up the hedged return of global bonds for each of the corresponding time periods, represented by

the blue dots. For example, on the US chart, the 200th observation is a return of 12.5%, the return for the 12 months ended April 30, 2005. Over the same period, the return of a global portfolio of long-dated bonds, hedged into US dollars, was 12.3%, also plotted at the 200th point on the x-axis. Based on the proximity of these returns, its clear that there is a high correlation between local and hedged performance. When domestic bond returns are strong, global returns tend to be strong as well. When domestic bond returns are weak, global returns tend to be weak. An examination of where the returns diverge, however, offers additional

Long-maturity global bonds are represented by the Barclays Capital GGCI 10+, which consists of government and credit bonds in this index with maturities of 10 years or longer. The index began in January 1999. Before that date, long-maturity global bonds are represented by the Citigroup WGBI 10+, consisting of government bonds in the Citigroup WGBI with maturities of 10 years or longer. Domestic long-maturity bonds are represented by the bonds for each individual market (the US, the UK, the euro area and Japan) in local currency within the Barclays Capital GGCI 10+ and Citigroup WGBI 10+. Prior to 1999, the euro area is represented by Germany only, with returns hedged into a weighted basket of European currencies.

LDI: Reducing Downside Risk with Global Bonds

Display 3

Pattern of Performance Is Similar

Local Bond Returns Ranked by Return vs. Hedged Global Bond Returns: Rolling 12-Month Periods
Local Hedged Global

60 40 Percent 20 0 (20) 0 60 40 Percent 20 0 (20) 0 100 100

US

60 40 Percent 20 0 (20) 200 300 60 40 Percent 20 0 (20) 200 300 0 50 100 0 100

Euro Area

200 Japan

300

UK

150

200

250

US and UK data begin December 31, 1985; euro-area data begin June 30, 1986 and Japan data begin September 30, 1988. Global bond portfolios represented by the Citigroup WGBI 10+ through December 1998 and the Barclays Capital GGCI 10+ from January 1999 through December 2011; domestic bond portfolios represented by each markets bonds within the Citigroup WGBI 10+ and the Barclays Capital GGCI 10+. Source: Barclays Capital, Citigroup and AllianceBernstein

insight into the advantages of including global bonds in an LDI portfolio. During periods of very poor domestic bond performancethe far-left regions of the graphs in Display 3global bonds tend to do better. During periods of very strong domestic bond returnson the far rightglobal returns tend to lag the individual countrys returns. The performance during the recent global financial crisis and recovery is a good illustration of these extremes. At the end of October 2008a period of significant underperformance in the US credit marketsa long-term US bond portfolio would have been down 9.9% (12-month annualized return). But a global portfolio hedged to US dollars would have lost just 2.5% over the same perioda much better outcome in a period of considerable market stress. However, global

investors would have sacrificed some of the upside of the dramatic recovery seen in the US credit markets in 2009at the end of October that year, a long US bond portfolio would have been up 27.2% (12-month annualized return), while a global bond portfolio hedged to US dollars would have gained only 15.1% over the same period. Since global returns are the average of several countries, it is not surprising that when the returns of one country are at an extremeeither positive or negativethe global average will be less extreme.

environmentwith yields on bonds near historical lows in many developed nationsdomestic 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. A global bond portfolio could improve a plans funding ratio by losing less. In periods when falling yields lead to strong domestic bond returns, liabilities are also likely to move higher. Here, a global bond portfolio may be a small drag if its returns are not as strong, but it

Better Downside Protection in a Rising Rate Environment

These results suggest that exposure to global bonds can mitigate the impact of very weak or even negative domestic returns. Given the current market

will typically still keep pace with a domestic-only bond portfolio.

Reducing Downside Risk While Capturing Bulk of Upside Gains

Another way to view the ability of long-term global bonds to lower downside risk while capturing most of the upside potential of long-term domestic bonds is to look separately at periods of negative and positive domestic returns. The first row of the table in Display 4 shows the frequency of rolling 12month periods with negative returns, comparing various regions domestic bonds with global bonds hedged into the relevant local currency. For every region we looked at but Japan, domestic bond returns were negative more often than hedged global returns were. The frequency of positive returns, shown in the second row, was higher for hedged global bonds than it was for domestic bondsexcept in Japan.
Display 4

The second section of the table shows average 12-month returns over periods when domestic bonds were negative or positive. Across negative periods, the average return for long-term US bonds in US dollars was (4.3)%. Over those same time periods, the average return for a US-dollar-hedged global portfolioincluding both negative and positive returnswas (1.9)%. In periods where long-term US bonds generated positive returns, the average return was 12.2%, while the hedged global return over the same periods averaged 10.8%. In short, a hedged global bond portfolio suffered less than half the decline seen in a US portfolio, but captured nearly 90% of the upside gain. The results for euro-based and yenbased investors were quite similar, while the results for sterling-based investors were outliers. A global portfolio hedged into sterling would actually have produced positive returns when gilt returns were negative and significantly

outperformed in periods when gilt returns were positive. While other markets generally had a positively sloped yield curve, the UK yield curve was inverted for most of the period analyzed, resulting in the underperformance of the UK bond portfolio relative to a hedged global portfolio.

A Natural Hedge Against Domestic Turmoil

Another benefit of exposure to global debt is that it is a very attractive hedge against the tail risk of a domestic government facing a credit crisis. Although tail-risk events areby definitionrare, recent financial problems in Greece and several other European countries, and the resulting turbulence in their government bond markets, have made such risks far more prominent for European investors. US investors do not usually share the same level of concern about a domestic credit crisis and US Treasuries normally

Hedged Global Long-Term Bonds Reduce Downside Risk

Domestic Long-Term Bonds vs. Hedged Global Long-Term Bonds: Rolling 12-Month Returns
US Frequency Rolling Returns < 0 Rolling Returns > 0 Average 12-Month Rolling Returns Local Rolling Returns < 0 Local Rolling Returns > 0 Downside Capture (Local Returns < 0) Upside Capture (Local Returns > 0) (1.9)% 10.8% (4.3)% 12.2% (0.1)% 10.9% (3.9)% 11.2% (0.7)% 7.1% (5.7)% 8.1% 1.5% 12.7% (3.2)% 11.1% Global 29 284 Local 41 272 Euro Area Global 29 278 Local 60 247 Japan Global 62 218 Local 48 232 Global 23 290 UK Local 33 280

43.3% 89.2%

2.7% 97.6%

11.5% 87.6%

(48.5)% 114.0%

US and UK data begin December 31, 1985; euro-area data begin June 30, 1986 and Japan data begin September 30, 1988. Global bond portfolios represented by the Citigroup WGBI 10+ through December 1998 and the Barclays Capital GGCI 10+ from January 1999 through December 2011; domestic bond portfolios represented by each markets bonds within the Citigroup WGBI 10+ and the Barclays Capital GGCI 10+. Source: Barclays Capital, Citigroup and AllianceBernstein

LDI: Reducing Downside Risk with Global Bonds

More Risk than Reward in Global Bonds?

Recent turmoil in the peripheral European sovereign-debt markets raises the question of whether the risks of adding exposure to a portfolio of global bonds outweigh the diversification benefits. If they were to, it would clearly be counterproductive for liability-driven investors. To determine whether including high-risk peripheral European sovereigns resulted in higher returns and skewed our data, we ran an additional analysis of the long-maturity global government bond market, grouping global sovereigns by yield into above-median and below-median yields, with the portfolios regrouped each month. As shown on the right, annualized returns for a hedged global sovereigns portfolio with below-median yields (Group 1) were slightly higher than for the portfolio of bonds with above-median yields (Group 2). Volatility for the portfolio with above-median yields was higher than for Group 1 but, perhaps surprisingly, not by very much. The return/risk ratios remained closefor the US and the UK, higher than the domestic-only portfolios. Our research indicates that the potential improvement in risk-adjusted returns from going global isnt merely the result of an increase in risk from exposure to high-yielding sovereign debt or a reaction to a unique time period or set of countries. Instead, it is simply the benefit of increased diversification. In this analysis, we grouped countries purely by yield in order to avoid hindsight bias, without any regard to fundamentals. However, we would argue against bond investors blindly following an index, which can lead to unintended consequences. A country issuing a great deal of debt, for example, is likely to account for a growing share of an index, but high debt levels are obviously a source of risk. While this is a separate issue, we believe that it is another area where active management can add value and reduce risk.

Citigroup WGBI 10+

Annualized Return and Volatility: January 1999June 2010
Group 1 USD Return Volatility Return/Risk 5.87% 6.16% 0.95 Below-Median Yields: Hedged Returns EUR 5.29% 6.19% 0.86 GBP 7.04% 6.24% 1.13 JPY 2.51% 6.18% 0.41

Group 2 USD Return Volatility Return/Risk 5.60% 6.83% 0.82

Above-Median Yields: Hedged Returns EUR 4.98% 6.89% 0.72 GBP 6.75% 6.91% 0.98 JPY 2.24% 6.86% 0.33

Domestic Government Bonds (10+ Years) USD Return Volatility Return/Risk 6.87% 9.93% 0.69 EUR 5.43% 6.68% 0.81 GBP 4.84% 7.65% 0.63 JPY 3.75% 5.88% 0.64

This analysis was completed for the period ending June 30, 2010. When updated through the end of 2011which would include periods of poor returns and significant volatility in the European sovereign-debt marketsthe return/risk ratios for the below-median yield group are higher in each base currency. The return/risk ratios for the above-median yield group are lower for US-dollar, euro- and sterling-based portfolios, but would exceed the ratios for domestic government bonds in the US, the euro area and the UK. Source: Barclays Capital, Citigroup and AllianceBernstein

benefit from a flight to quality reaction, but the risk of a credit event is not zero. For example, the US is facing a significant structural deficit, which is projected to increase as spending on entitlement programs such as Social Security and Medicare accelerates in the latter part of this decade.

The current assumption is that the threat of a potential crisis will ultimately spur the US government to act, but if the current political divide were to result in a deadlock preventing meaningful deficit reduction, further credit-rating downgrades could ensue, and financing costs could escalate as investors required greater compensation for holding US

debt. While this is not our base case scenario, it is certainly not unimaginable. Exposure to global bonds offers what amounts to a natural hedging strategy against domestic tail risk: global bonds offer a high correlation to domestic long-term bonds but protect against large downside losses in domestic bonds

Display 5

Limited Supply of Long-Maturity Bonds

10+ Year Bonds: Share of Total Domestic Market and Share of Global 10+ Year Market
50 40 Percent 30 20 10 0 10+ Year Bond Market Size (USD Trillions) US $2.06 Euro Area $1.55 Japan $2.06 UK $1.01 Domestic Global

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. To dimension the impact of moving to a more global approach, we looked at various combinations of domestic and nondomestic bonds. Adding even 10%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, as shown in Display 6. Nondomestic bonds can be added to a fixed-income portfolio in several ways:
n

As of December 31, 2011 Market size is represented by the market capitalization of the Barclays Capital GGCI for each region. Source: Barclays Capital

by giving up a small amount of the potential upside return. In contrast, many other tail-risk hedging strategies (such as put options on the S&P 500 Index) are now trading at premiums because so many investors are seeking to purchase tail-risk protection using these instruments.

Tapping into a Greater Supply of Bonds

One of the challenges when building a long-bond portfolio is the relatively small supply of bonds with longer maturities. In the US, the euro area and Japan, long-dated bonds represent less than a third of the market, as shown in Display 5. In the UK, long-dated bonds make up about half the market. Investors in any region could more than triple their long-maturity investment universe by going global.

to improve a plans funded ratio relative to its liabilities. However, while global bond exposure has many positives, we would not advise liability-driven investors to convert their entire fixed-income portfolios to global bonds. There is generally a close correlation between returns for domestic-only long bonds (we noted earlier that these are a reasonable proxy for liability changes) and hedged global bonds, but the gap between the two can be significant at times. Looking back at the periods examined in Display 2, page 2, the largest outperformance margin for domestic bonds over global bonds was 13.2% for a US dollarbased investor and 9.5% for a euro-based investor. However, the biggest gap was nearly 20% for sterlingand yen-based investors. In the UK and Japan, the correlation between domestic and global bond returns is lower. How large a global bond allocation should investors consider? The answer, of course, varies depending on each investors risk tolerance and specific home country. For

Investors can make a global allocation. In this case, nondomestic bonds are part of the portfolio benchmark and therefore allocations are strategic in nature. The portfolio manager can actively shift allocations within the portfolio between domestic and nondomestic bonds. Investors can add an international component to their asset allocation. This involves adding a portfolio of only nondomestic bonds. The investor (rather than the portfolio manager) must then monitor and adjust the size of the allocation to nondomestic bonds versus domestic bonds. Investors can permit the opportunistic use of nondomestic bonds within their domestic portfoliosa core plus approach to an LDI portfolio. In this case, the portfolio manager allocates between domestic and nondomestic bonds, but nondomestic bonds are

Sizing the Global Allocation

The ability of a hedged portfolio of global bonds to reduce downside risk while capturing most of the upside potential return creates an opportunity

LDI: Reducing Downside Risk with Global Bonds

Display 6

Sizing the Allocation to Global Bonds

Domestic Allocation Global ex Domestic Allocation US Annualized Returns Volatility Return/Risk Ratio Euro Area Annualized Returns Volatility Return/Risk Ratio Japan Annualized Returns Volatility Return/Risk Ratio UK Annualized Returns Volatility Return/Risk Ratio 9.7% 8.3% 1.2 10.2% 7.7% 1.3 10.9% 7.2% 1.5 11.5% 7.2% 1.6 11.9% 7.6% 1.6 6.0% 7.4% 0.8 6.0% 6.6% 0.9 6.0% 6.0% 1.0 6.0% 6.4% 0.9 5.9% 7.2% 0.8 8.4% 7.1% 1.2 8.7% 6.8% 1.3 9.1% 6.6% 1.4 9.4% 7.0% 1.3 9.7% 7.4% 1.3 10.1% 9.4% 1.1 9.7% 8.4% 1.2 9.2% 7.2% 1.3 8.6% 6.4% 1.3 8.2% 6.2% 1.3 100% 0% 80% 20% 50% 50% 20% 80% 0% 100%

unwanted source of risk to the portfolio. But this risk is easily mitigated by hedging the currency of the portfolio back to the investors base currency. Such hedges can be implemented simplyand cheaplythrough the use of currency forwards or futures. Operational considerations may also play a role. For example, a more complex custodial arrangement may be required to settle bonds denominated in nondomestic currencies.

Adding Global Exposure: A Better Strategy for Hedging Liabilities

Despite these concerns, our research strongly suggests that the increased diversification achieved by adding exposure to hedged global debt can improve the risk/return characteristics of an LDI portfolio when compared with the traditional domestic-only approach. These benefits are especially appealing in the current interest-rate environment. While rates may remain at low levels for an extended period of time, once they begin to rise toward more normal levels, lower returns for government bonds and a decline in liabilities are likely, making the diversification benefit of global exposure even more important. Of course, interest rates could decline even further, boosting the value of liabilities. But even if that happens, a hedged portfolio of global bonds would likely still be able to capture most of the upside return of domestic bonds while diversifying away some of the tail risk of an investors home-country debt. In summary, we believe that the overall evidence in favor of adding global exposure to LDI portfolios is compelling. n

The results of the analysis above cover a static time period and are for illustrative purposes only. US and UK data begin December 31, 1985; euro-area data begin June 30, 1986 and Japan data begin September 30, 1988. Global ex domestic bond portfolios represented by the Citigroup WBGI 10+ and Barclays Capital GGCI 10+ indices, excluding those bonds issued within the domestic market. Citigroup WGBI 10+ utilized through December 1998 and the Barclays Capital GGCI 10+ from January 1999 through December 2011. Domestic bond portfolios represented by each markets bonds within the Citigroup WGBI 10+ and the Barclays Capital GGCI 10+. Source: Barclays Capital, Citigroup and AllianceBernstein

not part of the benchmark; therefore, these allocations are tactical rather than strategic.

Why Arent Global Portfolios More Prevalent?

Given such a compelling potential improvement in risk-adjusted returns, why havent more liability-driven investors gone global in their long-duration portfolios? There are several possible reasons. Home-country bias likely plays a large roleinvestors have traditionally had a

preference for domestic assets when trying to better match the profile of their liabilitiesassuming that domestic bonds provide the most efficient match. However, as we have demonstrated, hedged global bonds have a high correlation with domestic debt, and the addition of even a modest allocation to hedged global bonds can meaningfully improve return/risk ratios. Another concern about global bond investing may be the impact of currency fluctuations, which can add an

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