Target date funds

Do international bonds improve target date funds?

Jan 18, 2017
By BlackRock

In today’s interest rate environment, fixed income allocations are getting increased scrutiny by plan sponsors. In particular, the question of whether adding international bond exposure to target date funds will improve diversification and generate stronger risk-adjusted returns remains a popular discussion point.

Our view

BlackRock’s Multi-Asset Strategy team systematically evaluates inclusion of various asset classes in LifePath® Target Date Funds, including global and international bond exposures. Even within our current capital market assumptions, our view remains that adding international bonds does potentially improve diversification, but may:

Introduce uncompensated currency risk

 
 

Introduce uncompensated currency risk

As much as half the risk in the Barclays Global Aggregate Index can be attributed to currency. Currency exposure can be very volatile in the short-term, but over the long run the estimated return is zero. In other words, adding global bonds introduces a generally uncompensated risk into the target date fund.

Create higher transaction and hedging costs

 
 

Create higher transaction and hedging costs

Accessing global bonds remains relatively more expensive than transacting domestic investment-grade bonds due to lower liquidity and lack of transparency in the international bond markets. In short, the additional expense of currency hedging may be a drag on returns.

Increase sovereign and political risk

 
 

Increase sovereign and political risk

A global bond allocation may increase exposure to countries with high debt-to-GDP ratios, as well as countries with higher political risk. This may increase the possibility of default risk in times of market stress. Conversely, it’s worth noting that in times of market stress, many global investors look to U.S. treasury bonds as a safe haven.

Fail to meaningfully improve risk-adjusted returns


Fail to meaningfully improve risk-adjusted returns

We believe that the case to justify introducing an asset class into a target date fund has to be strongly positive. But when we analyze both historical performance and BlackRock’s forward looking market assumptions of various asset classes, replacing domestic bonds with an unhedged global bond exposure potentially produces inferior risk-adjusted returns in an asset allocation strategy. Adding hedged global bonds potentially improves risk-adjusted returns modestly, but overall the risk, return and diversification characteristics of the hedged allocation are similar to that of domestic bonds.

Bottom line

BlackRock LifePath Target Date Funds, like most target date funds, currently have their highest exposure to fixed income assets for those individuals at or in retirement. So increasing risk, such as through currency exposure or regional political risk, should be carefully considered. Our bias will be to avoid adding a new asset class unless, having considered all factors, the anticipated improvement in risk-adjusted returns is sufficiently robust. Even in the changing fixed income environment, our analysis does not support adding international bonds to LifePath target date funds.

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