Many defined contribution 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 hedged global bonds might be one solution.
Fixed-income investment services are designed to meet investor objectives, from stability at the lower end of the risk/return spectrum to high income at the high-risk/high-potential-return end. 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 and high-income objectives lies the core objective. Core assets are those that tend to perform substantially better when the value of risk assets declines.
When equities and high yield are exhibiting a lot of volatility, plan sponsors and plan participants 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 U.S. plan sponsors have opted for a U.S. core or U.S. core-plus portfolio as the core option in their DC plan. However, some have begun to adopt global fixed income. These plan sponsors already understand that the potential benefits include overall diversification, risk mitigation during extreme downturns and a far broader opportunity set.
Unfortunately, what we've observed is that many adopters of global fixed income have been subjected to 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.
The error comes in buying global bonds that aren't currency-hedged. 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.