Duration Hedged Share Classes

From July 2018, GSAM no longer accepts subscriptions into these share classes

GSAM currently manages 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: 

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

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.

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.

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.