Hedged global bonds could be answer to DC volatility problem

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.

When we compare the three-year rolling standard deviation of both hedged and unhedged global bonds, as well as U.S. 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. U.S. bonds (represented by the Barclays U.S. Aggregate index) have been much less volatile.

But — drum roll, please — the hedged global approach (represented by the Barclays Global Aggregate hedged to the U.S. 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 stacked up (see chart).

All three fared about the same in terms of raw annualized returns.

But the risk-adjusted returns tell the full story. The Sharpe ratio, which measures return per unit of risk, climbs from global unhedged at 0.6 to U.S. at 0.9 to global hedged at 1.

Hedged global bonds 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, let's look at adding global to DC plans, both as a core option and as a component of the default option, such as a target-date fund.

Smaller plan sponsors have the ability to add global bonds as a complement to their U.S. bonds offering, and to guide participants toward increased allocations to it.

Larger plan sponsors have the flexibility to incorporate global bonds directly into their core bond option. This allows plan sponsors to design their core bond option to better meet participants' risk and return objectives, without creating disruption for plan participants.

And what is the right allocation for the core option, according to our research? Our historical study showed that any increased allocation to hedged global bonds improved potential risk-adjusted return. There is no “sweet spot,” nor does a sponsor or participant need to move to 100% hedged global in order to see results: a 10% or 50% allocation will show improvement in potential risk-adjusted reward, based on our analysis.

In an asset-allocation fund such as a target-date fund, we believe adopting at least a 50% hedged global bond allocation should benefit the portfolio.

So tap into the potential power of diversification. Open a broader opportunity set to active managers. But be sure to properly align the plan sponsor's or plan participant's investment objective — in this case, an offset to equity volatility — with the risk/return profile of the service by choosing hedged global rather than unhedged.