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August 2010
Diversification
Bonds are frequently viewed as an “anchor to windward,” offsetting the impact of poor stock market returns. However,
it appears that often mere lip service is paid to this objective and the spirit of the exercise becomes diluted. It is
easy to get enmeshed in the details of a bond mandate and lose sight of the need to address the desired level of
diversification.
In practice, how do typical bond portfolio allocations fare when the going gets rough on the equity seas? In a serious
equity bear market, it is reasonable to expect bonds to outperform as investors seek a safe haven. But what degree of
protection is expected and how much is provided by the typical bond portfolio? This, of course, is hard to determine
with much precision, but some worst-case scenario analysis is useful in gauging the utility of varying degrees of
diversification. As an illustration, we’ve chosen to look at the 30-year period beginning with 1980, selecting the
quarters characterized by negative returns of the S&P 500. These are displayed in Exhibit 1 and are sorted from most
to least severe.
Exhibit 1
Total Return
S&P 500
Quarterly 1980 – 2009
5%
0%
-5%
-10%
-15%
-20%
-25%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83
Exhibit 2
Total Return (75% Stock/25% Bond)
S&P 500, Barclays Aggregate and Government/Credit Bond Indexes
Quarterly 1980 – 2009
10%
0%
4Q07 2Q08
-5%
3Q08
1Q08
1Q09
-10%
S&P 500
-15%
Recent Equity Bear Market
4Q08 4Q07 through 1Q09
-20%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83
Source: GMO, Barclays
The portfolio returns corresponding to this 75/25 allocation are shown in Exhibit 3, making the point that such a
limited bond exposure provides little protection in difficult equity markets. Notably, in the most recent bear market, a
typical bond exposure provided a minimal cushion, except in the fourth quarter of 2008. Even in this case the positive
bond returns associated with a 25% allocation merely blunted the serious losses from stocks.
In the first quarter of 2009, the Long U.S. Government/Corporate component of the Barclays Aggregate actually
declined along with the stock market. More distressingly, for the recent bear equity market period extending from
4Q07 through 1Q09, the 46% decline in the S&P 500 was offset by only a 6% return for the longer-dated component
of the Barclays Index.
While bond returns are generally negatively correlated with falling stock prices, it’s clear that higher fixed income
allocations and/or longer duration portfolios are needed to provide a meaningful offset to many, but not all, equity
bear markets. Exhibit 4 illustrates the asset class returns that would have resulted from a 25% stock/75% bond asset
allocation.
0%
4Q07
2Q08
-15%
4Q08
Recent Equity Bear Market
4Q07 through 1Q09
-20%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83
Source: GMO, Barclays
Exhibit 4
Total Return (25% Stock/75% Bond)
S&P 500, Barclays Aggregate and Government/Credit Bond Indexes
Quarterly 1980 – 2009
10%
Barclays Long U.S.
Government/Credit
5%
Barclays Aggregate
0%
4Q07 2Q08
1Q08 3Q08
-5% S&P 500
1Q09
4Q08
-10%
-20%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83
10%
0% 4Q07
1Q08 2Q08
4Q08
-15%
Recent Equity Bear Market
4Q07 through 1Q09
-20%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83
Source: GMO, Barclays
Note that the longer-duration benchmark provided somewhat stronger protection against a falling equity market in the
fourth quarters of 1987 and 2008, while the Barclays Aggregate came up a bit short. However, even if interest rates
fall by the same amount in each equity market crash, the degree of protection delivered by a capitalization-weighted
index can vary meaningfully. For example, at the beginning of 4Q87, the Lehman Brothers Long U.S. Government/
Credit Index had a duration of 8.8 years, but this lengthened to 10.9 years by 4Q08. To avoid this duration drift, it
makes sense to consider a benchmark with a stable target duration implemented using non-callable, government
bonds, or associated derivatives.
It’s worth noting that the past 30 years hosted a significant decline in long-term interest rates, producing strong bond
market returns. Of course, the path was not smooth and this extended rally was periodically marked by periods of
rising bond yields. Note too that at lower yield levels, a bond’s sensitivity to changes in interest rates is increased.
Naturally, employing bonds as a hedge against significant equity losses requires a continuing assumption that the
returns of the respective asset classes will be negatively correlated as risk aversion rises.
Maturity
(Years) Weight
1 -1.8%
2 -0.1%
5 4.1%
10 12.1%
20 21.5%
30 41.3%
40 18.0%
50 4.9%
100.0%
Liability Value €245 million
This benchmark is straightforward and inexpensive to implement with interest rate swaps. The fact that it can be
easily replicated reduces tracking error, increasing the reliability of the hedge. Of course, the use of derivatives adds
complexity related to margin posting and collateral investment. In addition, the level of counterparty risk must be
weighed against the benefits offered by these instruments. Although more capital intensive, a portfolio of bonds with
similar interest rate and currency exposures can also provide an effective hedge. If liabilities are specified in real
terms, inflation swaps or inflation-linked bonds are natural vehicles to use. The hardest part of this exercise is deciding
how much exposure to hedge, not the mechanics of structuring the portfolio.
Deflation/inflation Protection
In the case of providing protection against inflation or deflation, as with equity diversification, an attempt must be
made to quantify the desired portfolio response. If inflation falls (or rises) by x%, what return is expected from the
fixed income assets?
Protection can be obtained through the use of bonds or derivatives. Their effectiveness naturally depends on how
closely their returns are correlated with changes in the price level one wants to hedge. Generally, hedging instruments
reference the most common measures of inflation at the consumer or national level. If the category of prices to be
hedged differs meaningfully from those referenced by popular indexes such as the broad CPI, alternative approaches
should be considered. Naturally, the closer the correlation between the risk one is trying to offset and the instruments
chosen to structure the hedge, the better the outcome. In certain cases it will be necessary to choose investment
vehicles that provide only moderate or loosely-correlated protection, or consider a customized over-the-counter bond
or derivative, which may prove to be quite expensive.
Inflation-linked bonds, interest rate swaps indexed to inflation/deflation, total return swaps, and bond futures provide
low-cost and effective means of delivering custom-tailored solutions. Derivative instruments are not cash-intensive,
so a relatively small proportion of portfolio assets needs to be allocated to do the job. Naturally the issues of margin
posting and collateral investment raised earlier apply here as well. Tailored instruments to hedge unusual risks are
likely to be expensive, inflexible, and illiquid, but their benefits may overcome these drawbacks.
Liquidity
Traditionally, investment-grade bonds have been a reliable source of liquidity. Naturally, shorter-dated government
and agency issues are the easiest and least expensive to sell, especially in a troubled market environment. Longer
maturity, lower credit quality bonds are generally a less reliable, and more costly, source of quick cash. Of course,
more exotic issues usually take a bit of time to liquidate and may involve some price concession to sell.
Not surprisingly, the breakdown of the fixed income markets in 2008 dramatically altered everyone’s perception of
liquidity. Market participants learned that off-the-run U.S. treasury bonds and inflation-protected notes can at times
become impossible to sell, except at fire sale prices. The crisis brought into focus the need for explicit liquidity
guidelines. Potential cash withdrawals over a specific horizon must be consistent with the investment strategy chosen.
Clearly, a portfolio of high yield bonds should not be relied on for liquidity in a market crisis. The more specific the
communication of liquidity preferences in various economic scenarios, the less chance there is for problems when
acute cash needs arise. Naturally, objectives must be consistent with the liquidity inherent in the chosen benchmark.
Beta Benchmark
The next step in the process is to turn the answers to the question of what role fixed income should play into an
investable benchmark. In some instances, such as the hedging of nominal liabilities, the benchmark is relatively
easy to establish. In others, such as diversifying equity returns, it is somewhat more difficult. Assumptions must be
made about the correlation of the benchmark portfolio and the risks to be hedged. Scenario analysis can be useful in
structuring benchmark portfolios in situations where the correlations are meaningfully below one.
In the case of equity diversification, for example, the correlation between stock and bond returns in an equity bear
market is not always negative, and the magnitude of bond returns for a given equity return is variable. So a generalized
approach, incorporating some assumptions, provides a way forward. It is very important to define the period over
which the hedge is expected to provide protection. The example below assumes a quarterly horizon. Of course, the
benefits of diversification tend to diminish as the horizon lengthens.
Say one wishes to offset a third of the S&P 500’s losses in any quarter by positive bond market portfolio returns. As
a very simplified example, assume that, in falling stock markets, the Barclays Long U.S. Government/Credit Index
produces positive returns equal to half of the equity market’s quarterly decline (this is a rough approximation of the
relationship observed over the 30-year period ending in 2009 in calendar quarters when the S&P 500 declined). The
following equation summarizes the desired result in a period of stock market losses:
% Stocks times Stock Return times 1/3 equals % Bonds times -1 times Bond Return
Since we expect that -1 times the Bond Return will equal half the (negative) Stock Return, we can rewrite our
equation as:
% Stocks times Stock Return times 1/3 equals % Bonds times Stock Return times 1/2
From this expression we can solve for the Stock/Bond allocation ratio.
So, % Stocks/% Bonds equals 1.5
Conclusions
The fundamental concept behind "New World Bond Management" is the alignment of investment objectives with
portfolio benchmarks. This is accomplished by clearly describing the goals for the bond portfolio and then designing
a benchmark that maximizes the likelihood of meeting them. Of course, the role of bonds must be viewed in the
context of the total plan asset allocation. The issues discussed in this paper are clearly a subset of the broader asset
allocation process through which exposures to a wide variety of beta and alpha risks are established. An important,
but secondary, process involves identifying potential sources of added value; incorporating them in, or layering them
on, the beta portfolio; and establishing realistic risk tolerances. When bond mandates are assembled in this fashion,
communication with the manager is well-defined and the primary purpose of owning bonds is not compromised by
poorly conceived benchmarks or excessive active risk.
Currency
Cumulative Liquidity
Investment Universe
Performance Objectives
Fee Structure
Illustrations of how each section of this template might be employed in connection with a sample global bond mandate
follow.
Total 100%
-OR-
Average Duration
Currency 100%
Normal Stressed
1-Day 10% 5%
1-Week 25% 13%
Cumulative Liquidity
1-Month 50% 25%
3-Months 90% 70%
Beta References
Term Structure Barclays Index Swaps
Currency JP Morgan Forward Indexes
Credit CDX Indexes
Emerging JP Morgan EMBI Global
*Can be specified as duration of % of index
Overnight Cash
3-Month
1-Year
2-Years +/- 10%
5-Years
10-Years +/- 15%
Term Structure (Nominal or 20-Years
Inflation-Linked) 30-Years +/- 10%
40-Years
50-Years
USD: +/- 35%, all developed market term
Total
structures permitted +/- 1 year
-OR-
Average Duration
Credit Duration* (May be Investment Grade Minimum rating: BBB, Range: +/- 2 years
static or dynamically set as a High Yield Minimum rating: CCC, Range: +/- 1 year
function of relative valuation) Emerging No local currency exposure, Range: +/- 2 years
Derivatives permitted
No: Equities, municipal bonds, convertibles
Investment Universe
Counterparties rated A or better, maximum 10%
Co-mingled funds require look-through
20 basis points
-Plus-
Base 25% of excess or return over beta, net of base fee
Fee Structure -Plus- and net of 3-month LIBOR;
Incentive subject to high water mark
Summary
These templates can be valuable tools for translating investment objectives into specific terms that managers can
use in establishing portfolios that capture the purpose of their clients’ bond portfolios. They provide parameters that
define the various risks that can be taken and document the business elements of the investment mandate. These
should be used as flexible tools, adapted as needed, to insure alignment of a client’s expectations, portfolios return
characteristics, and manager incentives.
Disclaimer: The views expressed herein are those of William Nemerever and are subject to change at any time based on market and other conditions. This is
not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for il-
lustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
Copyright © 2010 by GMO LLC. All rights reserved.