Bonds Without Borders or Benchmarks: A New Idea for DC Plans

WELLINGTON M ANAGEMENT

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December

2013

FOR PROFESSIONAL OR INSTITUTIONAL INVESTORS ONLY

Bonds Without Borders or Benchmarks: A New Idea for DC Plans

Tom Felago, CFA

Rich Gilmartin

About the Authors

Tom Felago is a senior member of the Defined Contribution Solutions Group. He is responsible for assisting clients with long-term investment strategy and policy issues. Rich Gilmartin is an Investment Director in Fixed Income Product Management. He works closely with fixed income investors to help ensure the integrity of their investment approaches, providing oversight of portfolio positioning, performance, and risk exposures.

Since the 2008 global financial crisis, defined contribution (DC) plan sponsors have been focused on actively reducing volatility and enhancing diversification for plan participants. Yet many DC plans continue to limit participants' fixed income options to those tightly managed to the Barclays US Aggregate Bond Index. This home-country bias and lack of flexibility limit opportunities to improve diversification and returns.

Indeed, the world has changed since US-focused approaches became the DC fixed income stan-

dard. Globalization has accelerated, advanced and developing economies have converged, and

a growing share of publicly traded debt,

including high-quality sovereign debt, has been issued outside the US. In other

K E Y POINTS

words, the universe of investment opportunities for active fixed income investors has grown dramatically.

In this paper, we argue that participants' risk and return objectives would be better served if the core DC menu included fixed income strategies that tap a global set of return sources. In addition, given the shortcomings of global bond benchmarks, we advocate an active, benchmark-agnostic approach, allowing for balanced exposure to high-quality sovereign debt while enabling opportunistic allocations to global fixed income and currency markets.

Fixed income exposure in DC plans remains

heavily US-focused at a time when the lowyield environment, unparalleled monetary expansion, and political brinkmanship make global diversification compelling.

Global mandates are typically tied to market-

cap-weighted benchmarks, which have several shortcomings, including significant exposure to highly indebted countries and risk profiles (duration, credit quality, etc.) driven by the market rather than participant objectives.

GDP-weighted benchmarks, though generally

more diversified than market-cap-weighted benchmarks, fall short on several counts, including high allocations to the most indebted countries and potentially higher volatility relative to market-cap-weighted benchmarks.

To complement existing US fixed income

options, we recommend a global approach that combines "smart beta" core allocations to high-quality sovereign markets with opportunistic sources of return.

Bonds Without Borders or Benchmarks: A New Idea for DC Plans

Expanding the Opportunity Set

While most DC menus offer opportunities for geographic diversification within equities, they still provide little if any non-US fixed income exposure. Instead, many plans rely on the Barclays US Aggregate Bond Index, resulting in a high concentration of US government-backed debt (US government securities represent more than 70% of the index1) and exposure to a single interest-rate cycle. The recent increase in US rates prompted by the Federal Reserve tapering comments highlights the risk this poses to participants. Additionally, high government debt, macro uncertainty, and the ongoing fiscal brinkmanship in Washington continue to raise questions about the "risk-free" status of US government bonds.

1Includes US Treasuries, US agencies, US agency MBS pass-throughs

Exposure to foreign bond markets can be thought of as diversification from unfavorable developments in the US. In addition, the global bond market provides skilled portfolio managers with a significant opportunity set for exploiting inefficiencies through country-rotation strategies, yieldcurve positioning, and currency and duration exposure.

The potential for diversification and enhanced returns is evident in the wide dispersion of the global bond market and its meaningful historical upside relative to the US bond market (Figures 1 and 2). Investing in a broad range of countries with varying economic cycles has also led to stronger risk-adjusted returns for a global portfolio (Figure 3) over the last 20 years.

Figure 1

Global Bond Market Returns Widely Dispersed

Global Government Bond Dispersion/Opportunity

60

Annual Total Returns (%)

40

20 US 0 -20 Japan

-40 2000

US Japan

Norway Australia

S Korea

Mexico

Slovenia Canada

Canada Singapore US

S Africa Taiwan Japan

Japan UK

2001 2002 2003 2004 2005 2006 2007 2008

*As of 31 August 2013. Indexes are unmanaged and not available for direct investment. Source: Barclays

Best

Chile S Africa

UK

Ireland Spain

Range of Returns Within Barclays Global Treasury Index

Worst

US

Japan

Ireland Cyprus

Japan

2009 2010 2011 2012 2013*

Barclays Global Treasury Index

Barclays US Treasury Index

Figure 2

US Market Returns More Narrowly Dispersed and Dominated by Credit Sectors US Bond Dispersion

30

Annual Total Returns (%)

20

C

G 10

C

G

C

G G

C 0

G

S

G

C G

G C

S G

C

C

G

C

G

S

G

G

-10

C

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

*As of 31 August 2013. Government is weighted average of US Treasury and government-related sectors of the Barclays US Aggregate. Source: Barclays

Wellington Management

2

Best Worst

Range of Returns Within Barclays US Aggregate Index

C

GC G

2013* S

Barclays US Aggregate Index Corporate Government Securitized

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Bonds Without Borders or Benchmarks: A New Idea for DC Plans

% %

Lastly, though we believe global exposure, both in fixed income and equities, makes long-term strategic sense for DC menus, global bonds may have an added tailwind now, since their yield is similar to that of US bonds. This comes after global yields trailed US yields for the last 15 years (Figure 4), contributing to two decades of US bond outperformance.

Figure 3

Risk-Adjusted Returns Favorable for Global Bonds

January 1990 ? July 2013

Global Aggregate Hedged

US Aggregate

Return

6.48%

6.62%

Risk

3.06%

3.73%

Sharpe Ratio

0.79

0.69

Sources: Barclays, Wellington Management

Figure 4

Global Yields Catch Up to US Yields

January 1990 ? July 2013

10 Global Aggregate

8

US Aggregate

Difference

6

4

2

0

-2 1/90 1/92 1/94 1/96 1/98 1/00 1/02 1/04 1/06 1/08 1/10 1/12

Sources: Barclays, Wellington Management

Drawbacks of Traditional Global Fixed Income Benchmarks

The built-in biases of traditional market-cap-weighted benchmarks are a challenge for all fixed income investors today. The most common concern is that, by definition, these indexes provide the greatest exposure to entities issuing the most debt. In the case of global bonds, the starkest example may be Japan, which grew from 10% of the Barclays Global Treasury Index in 1998 to more than 30% in 2008 (Figure 5).

In addition, market-cap-weighted indexes increase exposure to assets that have risen in price at the expense of those that have fallen in price. In other words, they buy high and sell low and are effectively backward looking. Finally, by accepting a broad market index as the benchmark, investors implicitly allow the market to dictate the duration, spread, sector composition, credit quality, and diversification of their bond market exposure. This can result in the

Figure 5

Composition of the Barclays Global Treasury Index

Historical Weights of Top 10 Countries

100

90

80

70

60

50

40

30

20

10

0 12/98

12/00

12/02

12/04

12/06

12/08

12/10

12/12

Rest of Index

Spain

United Kingdom

South Korea

Germany

United States

Netherlands

Italy

Japan

Canada

France

Sources: Barclays, Wellington Management

Wellington Management

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Bonds Without Borders or Benchmarks: A New Idea for DC Plans

risk profile of a plan participant's bond portfolio changing significantly because of market forces (Figure 6) rather than plan-appropriate risk targets.

GDP-Weighted Benchmarks: Better but Not Perfect

One alternative to traditional market-cap-weighted benchmarks gaining more attention is GDP-weighted indexes, which allocate sovereign bond exposure according to the size of the constituent countries' economies. This takes a step in the right direction, promoting better diversification than market-cap-weighted indexes and providing increased exposure to countries growing the fastest rather than those necessarily issuing the most debt. That said, GDP-weighted indexes are not without their drawbacks. For example, though the GDP-weighted Barclays Global Treasury Index has less exposure to Japanese sovereign debt than its market-cap-weighted counterpart (Figure 7), it retains high allocations to the developed world's most indebted issuers.

Additionally, given today's global GDP distribution, GDPweighted benchmarks generally have greater exposure to emerging markets. This can present practical hurdles to a true GDP-weighted portfolio when countries, such as China or India, have large economies and small or inaccessible sovereign debt markets.

Figure 6

Interest Rate and Credit Sensitivity of an Index Change Over Time

Monthly Spread and Duration of Barclays Global Aggregate Bond Index, December 1998 ? October 2013

160

28 Nov 2008

140

120

100

Spread (bps)

80 31 Dec 1998

60

40

31 Oct 2013

20

0 4.5 4.7 4.9 5.1 5.3 5.5 5.7 5.9 6.1 6.3

Duration

Sources: Barclays, Wellington Management

Figure 7

GDP-Weighted Benchmarks Still Have High Allocations to Indebted Countries Index Country/Region Exposure (% Market Value)

Barclays Global Treasury Index

US

Latin Am

Barclays Global Treasury, GDP-Weighted Index

Dollar Bloc

Other Europe

EMU

UK

Japan

Asia ex Japan

EE/Africa/ME

As of 31 December 2012 Sources: Barclays, Wellington Management

Wellington Management

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Bonds Without Borders or Benchmarks: A New Idea for DC Plans

Most critically, our research indicates that the performance of an economy as measured by GDP growth has not been a reliable indicator of future bond market returns. We examined the constituent countries of the GDP-weighted Barclays Global Treasury Index from 1999 to 2012 and found the correlation between current-year GDP growth and subsequent-year government bond return was a negligible 0.08.

We have also found that GDP weighting may increase volatility compared with a market-cap-weighted approach (Figure 8), largely because of the increased emerging market exposure. Lastly, whether using market-cap-weighted or GDP-weighted indexes, investors are effectively forced to hold debt in a host of countries (some of which may introduce unique volatility and liquidity issues) despite the fact that past a certain point the diversification benefit of investing in additional countries recedes quickly (Figure 9).

Expanding the DC Fixed Income Menu

In order to improve the effectiveness of the DC core menu, we suggest plan sponsors consider a global, benchmarkagnostic fixed income investment option. The objective is to enhance stability through greater diversification while seeking out the most attractive investment ideas from the global fixed income and currency markets without being constrained by a benchmark.

We believe a properly structured global approach can serve as an effective complement to existing core US fixed income options. Additionally, by moving away from a benchmark, managers have the flexibility to create a portfolio with a more consistent risk footprint and potentially greater downside protection.

Figure 8 GDP Weighting Adds Volatility

Initial Weighting

Market-Cap Weighted GDP Weighted

Number of Countries 37

35+

Standard Deviation* 2.89

3.52

*Based on annual returns from 1999 to 2012. Sources: Barclays (market cap), Wellington Management, FactSet (GDP)

Figure 9

Country Diversification Benefit Diminishes Quickly Total Return Volatility of GDP-Weighted Global Government Bond Indexes (Hedged to USD)

410

400

Projected Annual Total Return Volatility (bps)

390

380

370

360

4

6

8 10 12 14 16 18 20

Number of Countries Included

Sources: Wellington Management, FactSet

Wellington Management

5

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Bonds Without Borders or Benchmarks: A New Idea for DC Plans

The New Idea in Action: Our World Bond Approach

Wellington Management's World Bond approach seeks to address the issues highlighted in this paper. Its objective is to provide consistent risk-adjusted total return across various market environments with a low correlation to risk assets. The investment style is benchmark agnostic, and the portfolio structure consists of a risk-balanced global sovereign exposure combined with opportunistic sources of return (Figure 10).

Specifically, the approach begins with a "smart beta" core consisting of equal-weighted allocations to 10 ? 15 high-quality sovereign debt markets across traditional developed and emerging market countries. We believe this balanced approach can help avoid the concentration risks inherent in market-cap-weighted benchmarks.

To be included in this core part of the portfolio, sovereign bonds must demonstrate stable to improving credit quality (based on our proprietary analysis, not rating-agency opinion) and attractive valuations. They must also have a track record of high liquidity, which is of particular importance given that bond market liquidity has become more constrained since the 2008 financial crisis.

These core allocations are adjusted as conditions change over time, and they are complemented by potential opportunistic sources of return, such as country rotation, global securitized debt, global corporate bonds, and global high-yield bonds (Figure 11). Currency exposure, a critical element in global bond portfolios, is actively managed within a target band, typically 50% ? 100% hedged to the US dollar.

Our target-date approaches recently moved half of their US core bond exposure to the World Bond approach to potentially help improve diversification and pursue compelling returns in the face of low yields. For more detail, see "Preparing Retirement Portfolios for Lower Bond Returns."2

Figure 10 World Bond Portfolio Structure Risk Management

Opportunistic Sources of Return

Macro

Global High Yield

Smart Beta Core

Risk-Balanced Global Sovereign Exposures

Country Rotation

Global Corporate

Global Securitized

Figure 11 Opportunistic Sources of Return

Macro

Country Rotation Global Corporate

Global Securitized

Global High Yield

Research-driven investment approach based on rigorous fundamental and macroeconomic analysis to identify global investment themes

Systematic process seeks to identify misvaluation in developed market government yields

Combines top-down macro analysis with bottomup security selection in pursuit of undervalued investment grade credits

Top-down macroeconomic research and bottomup security analysis in pursuit of investment opportunities in structured finance markets

Bottom-up fundamental credit research with top-down sector analysis in pursuit of undervalued global high-yield opportunities

Source: Wellington Management

Source: Wellington Management

The above investment styles are typical of the World Bond investment approach. Actual experience may not reflect all of these categories depending on portfolio guideline restrictions and asset limitations.

2

Wellington Management

6

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