LDI: Reducing Downside Risk with Global Bonds
May 10, 2012
Despite compelling evidence in favor of global diversification, investors in many markets around the world continue to have a strong “home-country bias”— a preference for domestic over foreign assets. Nowhere is this tendency more apparent than in the ranks of liability-driven investors. But our research suggests that LDI investors, too, can reap significant benefits from going global.
Long-maturity hedged global bond returns are highly correlated with domestic bond returns and offer lower volatility. Crucially, global bonds tend to outperform when domestic bond returns are weak, offering better downside protection in a rising rate environment. At the same time, a portfolio of hedged global bonds tends to capture most of the upside gains of a domestic government bond portfolio. Exposure to global debt also offers what amounts to a natural tail-risk hedging strategy against a domestic credit crisis.
Overall, our research suggests that the increased diversification achieved by adding some exposure to long-maturity hedged global debt can improve the risk/return characteristics of an LDI portfolio over the traditional domestic-only approach. This is especially appealing in the current low-interest-rate environment.
Hedged Long-Term Global Bond Portfolios
Annualized Returns and Volatility: October 1987–December 2011