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Duration Hedged Share Classes

GSAM currently offers Duration Hedged share classes for specified bond funds in Goldman Sachs Funds, its UCITS-qualifying SICAV domiciled in Luxembourg. We describe duration hedging and explain GSAM’s approach to hedging the reference benchmark’s interest rate risk for its bond funds with duration hedged share classes.


 

Which Factors Impact the Change in Price of a Non-Government Bond?
 

Bonds yield a return, which is a combination of the income paid (coupon) and anticipated capital gains or losses. The yield compensates the investor for the risks of owning the bonds. Those risks generally fall into one of two broad categories: 

  1. Interest rate risk, otherwise referred to as duration risk and/or
  2. Credit risk and “other” risks specific to the bond issuer 

Figure 1: Fixed Rate Bonds Include Interest Rate Risk

fixed-rate-bonds

Source: GSAM. For Illustrative Purposes Only. The chart does not take into account potential default risk associated with Government Bonds.

What is duration risk?

It is the risk that a price of a bond falls when interest rates rise.

Why Does This Happen?

To demonstrate with an example:

  1. Assume you buy a bond with a par value of US$1000 at a price of US$950 with zero coupon, the yield is 5.26% (US$50/US$950);
  2. Assume interest rates then rise to 10% and new bonds are issued with a 10% yield;
  3. As an investor can now achieve 10% yield in the market, the price of the bond in (i) would need to fall commensurately to achieve the same yield;
  4. That would equate to the bond’s price falling to US$909 from US$950, with the yield now at US$91/US$909 at 10%.

As a result, changes in interest rates can influence the total return of a bond or bond portfolio. Duration risk can contribute positively to a bond’s total return when interest rates fall, but when interest rates rise, duration exposure will detract from returns. In other words, rising interest rates can have a negative impact on the total return of most bonds. Interest rate risk is typically a meaningful risk factor in most major types of bonds that pay a fixed interest rate, but that can vary substantially, e.g. (a) long dated bonds display higher duration risk when compared to short dated bonds, all else being equal; (b) lower quality bonds may have a lesser contribution from duration risk as a proportion of total risk versus a bond with higher credit quality. Some floating rate bonds such as bank loans also have less meaningful duration risk, because they have a periodic reset of the interest rate payable.


Why Hedge Interest Rate Risk (Duration Risk)?
 

Hedging duration risk allows investors to remove the interest rate risk, leaving the credit risk and other risk factors intact.

Figure 2: Removing Interest Rate Risk

removing-interest-rate-risk

When Might it Make Sense to Hedge Interest Rate Risk?
 

The case for investing in a duration hedged share class of a fund is most compelling when investors believe that interest rates are likely to rise. Duration hedged share classes will be of interest for investors who seek to be more exposed to credit risk with less exposure to interest rate risk. However, in an environment where interest rates are stable or falling, the duration component of a bond’s yield will contribute positively to total returns and a duration hedged portfolio is likely to underperform a portfolio, which is not duration hedged.


What is the Cost of Hedging?

Opportunity Cost

Most bonds include duration risk; a portion of the income provides compensation for this risk. When duration risk is hedged, the investor is forgoing the compensation for duration risk in exchange for removing the risk. Long term yields are generally higher than short term yields, therefore an investor in a duration hedged class is likely to experience reduced yield. Duration hedging also involves an opportunity cost, because the investor also gives up the upside potential of a general decline in interest rates, which could boost total returns.

Trading costs:

Whilst we would not expect them to be material, there are certain trading costs associated with implementing the hedging strategy for duration hedged classes through the use of financial derivative instruments.


How Duration Hedging Works In Goldman Sachs Asset Management Duration Hedged Share Classes
 

a. Whilst there are a number of different duration measures that can be used, the type of duration that we measure for these classes is that which is associated with the expected time for a bond to repay its cost rather than any duration measures that either (i) adjust for any deviations that may arise as a result of the use of derivatives or structured instruments or (ii) adjust for the different sensitivity of rates as it relates to bonds with significant credit risk (e.g. corporate bonds, high yield, emerging market debt). 

b. Goldman Sachs Asset Management duration hedged share classes only seek to hedge the duration risk associated with the underlying reference benchmark rather than the Fund’s specific duration risk. For example, if the overall portfolio of the Fund has a duration of 5.2 years and the Fund’s benchmark has a duration of 5.0 years, we will hedge 5.0 years of duration risk. In this case, the Fund will still have 0.2 years of duration risk. As a result, duration hedged share classes may still have some degree of duration risk.

To hedge duration risk, the fund will sell either financial futures or buy a swap, depending on which approach we deem more cost-effective for a fund.


Hypothetical Illustration of Risk Profile of Duration Hedging
 

Figure 3. Below illustrates the potential impact that duration hedging may have on three different types of bond funds in various scenarios.

In the first scenario, we estimate the risks across an eight-year market cycle using:

a. Actual weekly return data, and

b. Simulated return data that assumes the Fund’s duration risk was hedged.

The second scenario uses the same methodology to examine actual and simulated returns in two rising-rate environments.

The third scenario uses the same methodology to examine actual and simulated returns in two declining-rate environments.

While the duration hedged performance is hypothetical (simulated), it is important to note that as detailed in scenario 1 the overall risk profile of duration hedged share class of some funds such as the Global High Yield Portfolio and Global Emerging Markets Debt Portfolio is actually higher than the unhedged versions. Meanwhile, the results in scenarios 2 and 3 are consistent with the impact one would anticipate.

Figure 3. Scenario Analysis

Figure 3. Scenario Analysis

Example a) GS Global High Yield Portfolio

gl-high-yield-portfolio-chart

The scenario analysis data provided herein has certain limitations. Such data is hypothetical and does not represent actual trading, and thus may not reflect material economic and market factors, such as liquidity constraints. Simulated results are achieved by retroactively applying a model with the benefit of hindsight.This scenario analysis data is shown for illustrative purposes Past performance is not indicative of future performance which may vary.

Example b) GS Global Emerging Markets Debt Portfolio

gs-emd-portfolio-chart

The scenario analysis data provided herein has certain limitations. Such data is hypothetical and does not represent actual trading, and thus may not reflect material economic and market factors, such as liquidity constraints. Simulated results are achieved by retroactively applying a model with the benefit of hindsight. This scenario analysis data is shown for illustrative purposes Past performance is not indicative of future performance which may vary.

Example b) GS Global Emerging Markets Debt Portfolio

gl-credit-portfolio-chart

The scenario analysis data provided herein has certain limitations. Such data is hypothetical and does not represent actual trading, and thus may not reflect material economic and market factors, such as liquidity constraints. Simulated results are achieved by retroactively applying a model with the benefit of hindsight. This scenario analysis data is shown for illustrative purposes Past performance is not indicative of future performance which may vary.

Some Other Important Points to Note When Investing in Duration Hedged Share Classes Include:
 

  1. Duration hedged share classes aim to lower the interest rate risk (duration) of the underlying reference fixed-income benchmark back to three-month LIBOR (the interbank lending rate). The hedge will be implemented using interest rate swaps or other derivatives, to reflect the profile of the expected coupons and maturities of the securities in the benchmark.

    The hedging mechanism will seek to leave the credit risk component unchanged. It is observed that credit risk and duration risk in bonds tend to offset one another to a certain extent. Thus when duration risk is hedged, the offsetting effect is removed and the remaining credit risk, when significant in the case of high yield bonds for example, can be greater than the original, unhedged, risk. This was shown earlier with the historical returns and risk analysis. 

    Historical analysis shows that a bond with a credit component has a different level of sensitivity to changes in swap rates than a bond with no credit component. Generally, the greater the credit component, the less impact changes in swap rates will have on the value of a bond, all else being equal. Therefore, hedging with a duration measure that does not adjust for this historical characteristic may lead to in effect over-hedging if the underlying reference benchmark contains a large proportion of bonds with a credit component – we will not seek to adjust for this.

  2. Counterparty risk – as the implementation of the hedging strategy is achieved through the use of over-the-counter financial derivative instruments, there is additional counterparty exposure.


Appendix

What is duration?

Duration is the expected percent price change of a security associated with a 1% change in interest rates. Factors that affect a bond’s duration include:

a.   Time to maturity: Bonds with longer maturities have greater sensitivity to interest rate changes. For example, a bond that matures in one year will more quickly repay its true cost than a bond that matures in 10 years. As a result a bond that has a relatively shorter term to maturity would have lower duration and less price risk.

b.   Coupon rate: A bond’s payment is a key factor in calculating. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost more quickly than the lower yielding bond – therefore the bond with a higher coupon rate would have a lower duration.