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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.
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:
It is the risk that a price of a bond falls when interest rates rise.
To demonstrate with an example:
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.
Hedging duration risk allows investors to remove the interest rate risk, leaving the credit risk and other risk factors intact.
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.
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.
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.
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.
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.
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.