new bond world management

8/8/2019 New Bond World Management

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GMOWHITE P APER

August 2010

New World Bond Management:A Practical Framework for Decision Making

Bill Nemerever

Setting the StageOn a recent business trip we were surprised when the CIO of a large pension plan asked how he should structure his

bond portfolio. There had been a recent change in fund management personnel at his rm and the internal investmentteam was interested in starting with a clean slate, free from the biases and legacies embedded in their current xedincome allocation. Usually these meetings are oriented around a product the bond manager wants to sell, rather thanone that might meet a clients needs. We have some strong opinions about the proper way to think about xed income.Previous GMO white papers, What Should You Pay for Alpha? and Bond Benchmark Baloney , have highlighted our observations on some of the markets peculiarities with respect to the pricing of added value (alpha), and in the choiceof bond benchmarks. This paper is an attempt to answer the question of how to structure a bond portfolio in moredepth, proposing a methodology to address the elusive issue of the role bonds should play in asset allocation.

In our view, the determination of the appropriate allocation to xed income, and the pursuit of related alpha, ismost often done in a fairly conventional fashion, negatively in uenced by many of the common misconceptions thatsurround the asset class. We believe that the appropriate starting point must be to answer the question, What purpose

do I expect my allocation to

xed income to play in my total portfolio? The most common responses are:Diversify my exposure to equity market declines.

Hedge the interest rate risk in my liabilities.

Mitigate the effects of de ation or in ation.

Obtain foreign bond and currency diversi cation.

Provide a source of liquidity.

The following illustration is a light-hearted characterization of our view of todays world of xed income.


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2GMO New World Bond Management August 2010


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GMO New World Bond Management August 2010 3

Why Own Bonds? Naturally, there are a variety of reasons for owning bonds, not all independent of each other, and they are primarilyrelated to risk control. (Note that adding value through active management is not usually one of the responses.) Oncethe reasons for owning bonds have been identi ed, the next step is to establish benchmark and investment approachesthat align with these objectives.

The sections that follow outline a framework for addressing the most important decisions affecting a bond portfolio.In addition, we provide an appendix with detailed templates that can be used in designing useful benchmarks andcommunicating clearly with investment managers.

The role a bond portfolio plays varies from sponsor to sponsor, and meaningfully depends on its interaction with theother asset classes represented. This paper is not intended to prescribe speci c solutions or stray beyond xed income,

but is meant to highlight the issues involved and provide a practical approach to translate the answer to the questionWhy own bonds? into an effective portfolio.

Diversi cationBonds are frequently viewed as an anchor to windward, offsetting the impact of poor stock market returns. However,it appears that often mere lip service is paid to this objective and the spirit of the exercise becomes diluted. It iseasy to get enmeshed in the details of a bond mandate and lose sight of the need to address the desired level of

diversi cation.

In practice, how do typical bond portfolio allocations fare when the going gets rough on the equity seas? In a seriousequity bear market, it is reasonable to expect bonds to outperform as investors seek a safe haven. But what degree of

protection is expected and how much is provided by the typical bond portfolio? This, of course, is hard to determinewith much precision, but some worst-case scenario analysis is useful in gauging the utility of varying degrees of diversi cation. As an illustration, weve chosen to look at the 30-year period beginning with 1980, selecting thequarters characterized by negative returns of the S&P 500. These are displayed in Exhibit 1 and are sorted from mostto least severe.

Exhibit 1Total Return

S&P 500Quarterly 1980 2009

Source: GMO, Barclays

-25%

-20%

-15%

-10%

-5%

0%

5%

4 Q 8 7

4 Q 0 8

3 Q 0 2

3 Q 0 1

3 Q 9 0

2 Q 0 2

1 Q 0 1

1 Q 0 9

3 Q 8 1

3 Q 9 8

1 Q 0 8

3 Q 0 8

4 Q 0 0

1 Q 8 2

3 Q 9 6

3 Q 9 9

1 Q 8 0

3 Q 8 5

1 Q 9 4

4 Q 0 7

1 Q 0 3

1 Q 9 0

2 Q 0 8

2 Q 0 0

2 Q 8 4

1 Q 9 2

1 Q 8 4

2 Q 8 1

1 Q 0 5

3 Q 0 4

2 Q 8 2

2 Q 0 6

3 Q 0 0

2 Q 9 1

3 Q 8 3


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The portfolio returns corresponding to this 75/25 allocation are shown in Exhibit 3, making the point that such alimited bond exposure provides little protection in dif cult equity markets. Notably, in the most recent bear market, atypical bond exposure provided a minimal cushion, except in the fourth quarter of 2008. Even in this case the positive

bond returns associated with a 25% allocation merely blunted the serious losses from stocks.

In the rst quarter of 2009, the Long U.S. Government/Corporate component of the Barclays Aggregate actuallydeclined along with the stock market. More distressingly, for the recent bear equity market period extending from4Q07 through 1Q09, the 46% decline in the S&P 500 was offset by only a 6% return for the longer-dated componentof the Barclays Index.

While bond returns are generally negatively correlated with falling stock prices, its clear that higher xed incomeallocations and/or longer duration portfolios are needed to provide a meaningful offset to many, but not all, equity

bear markets. Exhibit 4 illustrates the asset class returns that would have resulted from a 25% stock/75% bond assetallocation.

An effective bond portfolio hedge should offset a signi cant portion of the equity losses. For our illustration (seeExhibit 2), we picked a dramatically simpli ed 75% stock/25% bond asset mix allocated between the S&P 500 andthe Barclays (formerly Lehman Brothers) Aggregate Bond Index (or a longer-duration subset of the Index). This is a

bare-bones representation of a typical allocation for aggressive investors.

Naturally, plans actually hold a wide variety of asset classes. And, their interactions are complex. Our example is provided to illustrate the point that low allocations to intermediate-duration bonds will not meaningfully offset seriousequity market declines. The 25% allocation to the Barclays Aggregate, shown in green in the following chart, doeslittle to mitigate the pain. Even if bonds were invested in the longer-duration (currently about 11 years), Long U.S.Government/Credit component of the Index shown in blue, little relief is obtained.

Exhibit 2Total Return (75% Stock/25% Bond)S&P 500, Barclays Aggregate and Government/Credit Bond IndexesQuarterly 1980 2009


-20%

-15%

-10%

-5%

0%

5%

10%

4 Q 8 7

4 Q 0 8

3 Q 0 2

3 Q 0 1

3 Q 9 0

2 Q 0 2

1 Q 0 1

1 Q 0 9

3 Q 8 1

3 Q 9 8

1 Q 0 8

3 Q 0 8

4 Q 0 0

1 Q 8 2

3 Q 9 6

3 Q 9 9

1 Q 8 0

3 Q 8 5

1 Q 9 4

4 Q 0 7

1 Q 0 3

1 Q 9 0

2 Q 0 8

2 Q 0 0

2 Q 8 4

1 Q 9 2

1 Q 8 4

2 Q 8 1

1 Q 0 5

3 Q 0 4

2 Q 8 2

2 Q 0 6

3 Q 0 0

2 Q 9 1

3 Q 8 3

S&P 500

Barclays Long U.S.Government/Credit Barclays Aggregate

Recent Equity Bear Market 4Q07 through 1Q09 4Q08

2Q08

1Q09

3Q08

4Q07

1Q08


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Source: GMO, Barclays Exhibit 4Total Return (25% Stock/75% Bond)S&P 500, Barclays Aggregate and Government/Credit Bond IndexesQuarterly 1980 2009


-20%

-15%

-10%

-5%

0%

5%

10%

4 Q 8 7

4 Q 0 8

3 Q 0 2

3 Q 0 1

3 Q 9 0

2 Q 0 2

1 Q 0 1

1 Q 0 9

3 Q 8 1

3 Q 9 8

1 Q 0 8

3 Q 0 8

4 Q 0 0

1 Q 8 2

3 Q 9 6

3 Q 9 9

1 Q 8 0

3 Q 8 5

1 Q 9 4

4 Q 0 7

1 Q 0 3

1 Q 9 0

2 Q 0 8

2 Q 0 0

2 Q 8 4

1 Q 9 2

1 Q 8 4

2 Q 8 1

1 Q 0 5

3 Q 0 4

2 Q 8 2

2 Q 0 6

3 Q 0 0

2 Q 9 1

3 Q 8 3

S&P 500

Barclays Long U.S.Government/Credit

Barclays Aggregate

Recent Equity Bear Market 4Q07 through 1Q09

4Q08

2Q08

1Q09

3Q084Q07

1Q08

-20%

-15%

-10%

-5%

0%

5%

10%

4 Q 8 7

4 Q 0 8

3 Q 0 2

3 Q 0 1

3 Q 9 0

2 Q 0 2

1 Q 0 1

1 Q 0 9

3 Q 8 1

3 Q 9 8

1 Q 0 8

3 Q 0 8

4 Q 0 0

1 Q 8 2

3 Q 9 6

3 Q 9 9

1 Q 8 0

3 Q 8 5

1 Q 9 4

4 Q 0 7

1 Q 0 3

1 Q 9 0

2 Q 0 8

2 Q 0 0

2 Q 8 4

1 Q 9 2

1 Q 8 4

2 Q 8 1

1 Q 0 5

3 Q 0 4

2 Q 8 2

2 Q 0 6

3 Q 0 0

2 Q 9 1

3 Q 8 3

75% S& P 500/25%Barclays Long U.S.Government/Credit

75% S&P 500/25%

Barclays Aggregate


4 Q 0 8

2 Q 0 8

1 Q 0 9

3 Q 0 8

4 Q 0 7

1 Q 0 8


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Note that the longer-duration benchmark provided somewhat stronger protection against a falling equity market in thefourth quarters of 1987 and 2008, while the Barclays Aggregate came up a bit short. However, even if interest ratesfall by the same amount in each equity market crash, the degree of protection delivered by a capitalization-weighted

index can vary meaningfully. For example, at the beginning of 4Q87, the Lehman Brothers Long U.S. Government/Credit Index had a duration of 8.8 years, but this lengthened to 10.9 years by 4Q08. To avoid this duration drift, itmakes sense to consider a benchmark with a stable target duration implemented using non-callable, government

bonds, or associated derivatives.

Its worth noting that the past 30 years hosted a signi cant decline in long-term interest rates, producing strong bondmarket returns. Of course, the path was not smooth and this extended rally was periodically marked by periods of rising bond yields. Note too that at lower yield levels, a bonds sensitivity to changes in interest rates is increased.

Naturally, employing bonds as a hedge against signi cant equity losses requires a continuing assumption that thereturns of the respective asset classes will be negatively correlated as risk aversion rises.

Hedging Speci c Liabilities

Nailing down the speci c reasons for holding xed income makes benchmark selection a lot easier. Endowmentsand foundations may have forecasts of future expenditures to be funded and hedged against changes in interest rates.Similarly, pension plan liabilities are increasingly part of the risk equation for corporations and public funds.

Regulatory changes in many countries are moving pension disclosure from nancial footnotes to balance sheets andincome statements. Bonds are almost perfect vehicles for hedging nominal liabilities. Once it has been determinedhow much of a hedge is desired, a plans actuaries can provide a schedule of speci c risk-free interest rate exposuresto serve as a benchmark. Exhibit 6 shows an example of a portfolio of interest rate swaps designed to match a portionof a European industrial companys liabilities.

Clearly, a dramatically larger allocation to bonds provided a signi cantly more effective offset to negative equityreturns than our previous 75/25 example, as illustrated by the chart of portfolio returns shown in Exhibit 5.


-20%

-15%

-10%

-5%

0%

5%

10%

4 Q 8 7

4 Q 0 8

3 Q 0 2

3 Q 0 1

3 Q 9 0

2 Q 0 2

1 Q 0 1

1 Q 0 9

3 Q 8 1

3 Q 9 8

1 Q 0 8

3 Q 0 8

4 Q 0 0

1 Q 8 2

3 Q 9 6

3 Q 9 9

1 Q 8 0

3 Q 8 5

1 Q 9 4

4 Q 0 7

1 Q 0 3

1 Q 9 0

2 Q 0 8

2 Q 0 0

2 Q 8 4

1 Q 9 2

1 Q 8 4

2 Q 8 1

1 Q 0 5

3 Q 0 4

2 Q 8 2

2 Q 0 6

3 Q 0 0

2 Q 9 1

3 Q 8 3

25% S& P 500/75%Barclays Long U.S.Government/Credit

25% S&P 500/75%Barclays Aggregate


4Q082Q08

1Q09

3Q08

4Q07

1Q08



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sovereign, agency, multi-national, or corporate. Of course, interest rate and currency exposures can also be acquiredusing derivatives such as futures, swaps, or forwards. Although developed market interest rates have converged and

become more correlated, future changes in fundamentals, such as relative in ation rates or scal instability, will causethem to diverge. Foreign interest rate and currency risks, to the extent that they are independent of their counterpartsin an investors home market, will diversify portfolio returns. Foreign bonds are also well-suited to hedging liabilitiesdenominated in foreign currencies and/or tied to foreign term structures and/or in ation.

Again, the speci c exposures to foreign bonds and currencies can be inferred from the answers to the question of whattype and degree of diversi cation is desired.

LiquidityTraditionally, investment-grade bonds have been a reliable source of liquidity. Naturally, shorter-dated governmentand agency issues are the easiest and least expensive to sell, especially in a troubled market environment. Longer maturity, lower credit quality bonds are generally a less reliable, and more costly, source of quick cash. Of course,more exotic issues usually take a bit of time to liquidate and may involve some price concession to sell.

Not surprisingly, the breakdown of the xed income markets in 2008 dramatically altered everyones perception of liquidity. Market participants learned that off-the-run U.S. treasury bonds and in ation-protected notes can at times

become impossible to sell, except at re sale prices. The crisis brought into focus the need for explicit liquidity

guidelines. Potential cash withdrawals over a speci c horizon must be consistent with the investment strategy chosen.Clearly, a portfolio of high yield bonds should not be relied on for liquidity in a market crisis. The more speci c thecommunication of liquidity preferences in various economic scenarios, the less chance there is for problems whenacute cash needs arise. Naturally, objectives must be consistent with the liquidity inherent in the chosen benchmark.

Beta BenchmarkThe next step in the process is to turn the answers to the question of what role xed income should play into aninvestable benchmark. In some instances, such as the hedging of nominal liabilities, the benchmark is relativelyeasy to establish. In others, such as diversifying equity returns, it is somewhat more dif cult. Assumptions must bemade about the correlation of the benchmark portfolio and the risks to be hedged. Scenario analysis can be useful instructuring benchmark portfolios in situations where the correlations are meaningfully below one.

In the case of equity diversi cation, for example, the correlation between stock and bond returns in an equity bear market is not always negative, and the magnitude of bond returns for a given equity return is variable. So a generalizedapproach, incorporating some assumptions, provides a way forward. It is very important to de ne the period over which the hedge is expected to provide protection. The example below assumes a quarterly horizon. Of course, the

bene ts of diversi cation tend to diminish as the horizon lengthens.

Say one wishes to offset a third of the S&P 500s losses in any quarter by positive bond market portfolio returns. Asa very simpli ed example, assume that, in falling stock markets, the Barclays Long U.S. Government/Credit Index

produces positive returns equal to half of the equity markets quarterly decline (this is a rough approximation of therelationship observed over the 30-year period ending in 2009 in calendar quarters when the S&P 500 declined). Thefollowing equation summarizes the desired result in a period of stock market losses:

% Stocks times Stock Return times 1/3 equals % Bonds times -1 times Bond Return

Since we expect that -1 times the Bond Return will equal half the (negative) Stock Return, we can rewrite our equation as:

% Stocks times Stock Return times 1/3 equals % Bonds times Stock Return times 1/2

From this expression we can solve for the Stock/Bond allocation ratio.

So, % Stocks/% Bonds equals 1.5


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In this case then, an allocation of $100 to the S&P 500 accompanied by a $67 allocation to the Barclays Index (roughlya 60/40 allocation) could be expected, on average, to produce approximately the degree of protection desired, providedour assumptions are in the right ballpark. Of course, an even longer-duration bond portfolio would be less capitalintensive and provide approximately the same degree of protection.

Naturally the relationship between quarterly stock and bond index returns when equity markets fall is, as shown inthe charts discussed earlier, quite variable. A more reasonable way of addressing the issue is to examine the changesin interest rates that accompany falling stock markets and establish a government bond benchmark with a durationcalibrated to produce the desired result. While there are many ways to approach this problem, the important point is tode ne the risks to be diversi ed, the period over which protection is desired, the degree of protection to be targeted,and the instruments to be employed.

The illustration above highlights the variability inherent in hedging a risk where the relationship between the hedgedand hedging assets equities and bonds is somewhat uncertain. Of course, the more bond-like the purpose of the xed income allocation, the more effective bonds will be in ful lling it. Again, a good example of a nearly perfect tis that of pension liabilities that can be easily incorporated in an investable benchmark.

Thus benchmarks are arrayed along an effectiveness continuum. Their position is determined by the alignment of theobjectives for the bond portfolio and the availability of market instruments whose returns are highly correlated withthe objective. However, the lack of perfect hedging vehicles should not dissuade one from structuring a bond portfolioto achieve the best result possible, even though a degree of uncertainty will remain.

At this stage, it is important to remember that the major risks in xed income investing are interest rate risks. Giventhe broad array of developed markets interest-rate derivatives, market exposure can be achieved with relatively littlecash commitment. Most of the change in a bonds price can be explained by changes in the government bond termstructure of interest rates in the country in whose currency the bond is denominated. Thoughtful incorporation of theserisks in the benchmark should be the primary focus.

The issues highlighted above can be used to organize the process of producing more speci c answers to the question,Why do I own bonds? Once this question is answered, a benchmark laying out the risk-free interest rate, and

possibly currency, exposures can be created. Issues such as market sector or credit exposure are secondary. However,if desired, speci c structural sensitivity to various sectors, such as investment-grade credit, can easily be incorporatedwithout compromising the primary reason for holding bonds.

Obviously, there are many trade-offs, and perhaps con icting objectives, that must be balanced. However, withoutsome speci city at this stage, constructing a thoughtful bond portfolio is more or less left to chance. An investmentconsultant can be very helpful in highlighting the various scenarios and nding reasonable and practical solutions.

The Alpha PortfolioOnce the basic benchmark is in place, attention can be focused on adding value to its return from active bond andcurrency strategies. Importantly, active strategies must be employed in a way that doesnt dilute signi cantly thechances of realizing the primary objective of the xed income portfolio. Strategies incorporating high-yield bonds,emerging country debt, corporate securities, or hedge funds are consumers of cash.

Other strategies may be implemented using derivatives, thus requiring more modest cash commitments. However,intelligent management of collateral is imperative. The leverage inherent in derivative positions demands anunimpaired ability to meet margin calls, especially during a liquidity crisis like that experienced in 2008. Althoughthere is generally no compelling nancial reason to connect these active strategies with the benchmark, many ndthis a more understandable and acceptable structure. Realistically, though, the selection of active bond and currencystrategies should focus on:


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How much con dence does one have in the manager?

What market inef ciencies are they exploiting?

What sort of information ratio can one expect?

Is their added-value correlated with some systematic market risk like that embedded in equities, or with that of other active managers?

It is important to consider the diversifying properties of a value-added process. An investment strategy that generallyadds to risks embedded in existing portfolios is much less valuable than one that is truly different. For example, ahigh-yield, credit-based xed income strategy may be highly correlated with equity market returns. Its best to avoid

paying alpha-based fees for beta risk, especially when more of that speci c risk is not desirable. An alpha processthat has low correlation to both beta exposures and other value-added strategies can be a meaningful contributor to

portfolio ef ciency, adding another dimension to excess returns.

Although active xed income strategies are generally embedded in the xed income allocation, their selection andsizing should be part of the total alpha allocation process.

ConclusionsThe fundamental concept behind "New World Bond Management" is the alignment of investment objectives with

portfolio benchmarks. This is accomplished by clearly describing the goals for the bond portfolio and then designinga benchmark that maximizes the likelihood of meeting them. Of course, the role of bonds must be viewed in thecontext of the total plan asset allocation. The issues discussed in this paper are clearly a subset of the broader assetallocation process through which exposures to a wide variety of beta and alpha risks are established. An important,

but secondary, process involves identifying potential sources of added value; incorporating them in, or layering themon, the beta portfolio; and establishing realistic risk tolerances. When bond mandates are assembled in this fashion,communication with the manager is well-de ned and the primary purpose of owning bonds is not compromised by

poorly conceived benchmarks or excessive active risk.


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Appendix:

A Template for Organizing DecisionsIn this appendix we provide a framework for:

I. Converting xed income asset class objectives to speci c benchmark (beta) exposures,

II. Specifying active management guidelines with respect to the benchmark, and

III. De ning the structure of the mandate with respect to investment universe, performance objective, andincentive fee structure.

The following exhibit is a generalization of the template to be used to guide decisions made with regard to these threeelements of a xed income mandate.

Illustrations of how each section of this template might be employed in connection with a sample global bond mandatefollow.

II. Active Management Guidelines

Currency

III. Account Structure

Investment Management Template

I. Beta Exposures

Term Structure (Nominal or Inflation-Linked)

Credit Duration* (May be static or dynamically set as a function of relative valuation)

Cumulative Liquidity

Investment Universe

Performance Objectives

Fee Structure


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I. Beta ExposuresAs expressed earlier, the process must begin with a fairly speci c expression of what the expectations are for the

bond portfolio allocations. Of course, the more de nitive the expectation, such as, I want to match my retired lifeliabilities, the more precise the benchmark. And, the more the expectations are related to nominal interest rates, themore effective a portfolio of nominal bonds will be. Of course there are many other xed income instruments suchas index-linked bonds and total return swaps that can be employed in the speci cation of a suitable benchmark. Theimportant objective is to craft a benchmark that can be replicated in an acceptable fashion using available nancial

instruments.

De ning expectations is the most dif cult step in the process since the inability to be speci c about ones objectives,or the lack of suitable instruments to obtain appropriate exposures, must be addressed before proceeding.

For illustrative purposes we will use a simple liability benchmark to show how our template can be applied. This benchmark concentrates the interest rate risk in interest rate swaps at three maturities: 2 years, 10 years, and 30years.

Risk exposures may be speci ed in four dimensions. Note that these exposures are independent of the instrumentsused to achieve them.

Term structure, the most important factor, de nes the exposure to risk-free interest rates, nominal or real. The1.

speci cation format is exible enough to accommodate a detailed liability-based objective, or can be de nedsimply as average duration. Exposure can be broadened to foreign term structures.

Currency exposure can be entirely in the home currency or distributed more broadly.2.

Credit duration can be speci ed for investment grade corporate bonds, high yield corporate bonds, and/or emerging3.country debt. If more useful, the benchmark exposures to these credit sectors can be expressed as percentages of market value invested in referenced indexes.

Cumulative liquidity preferences are expressed in a table listing, for both a normal and stressed environment,4.the percentage of account assets that can be sold, in the required time frame, at or near current valuations.

All beta exposures are speci ed in terms of investable indexes or instruments.


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U.S. Euro U.K. Japan CanadaOvernight Cash

3-Month1-Year

2-Years 15%5-Years

10-Years 45%20-Years30-Years 40%40-Years50-Years

Total 100%

-OR- Average Duration

Currency 100%

Investment Grade 1.5 yearsHigh Yield 2 yearsEmerging 1 year

Normal Stressed1-Day 10% 5%

1-Week 25% 13%

1-Month 50% 25%3-Months 90% 70%

I. Beta Exposures




Beta References

Term Structure Barclays Index SwapsCurrency JP Morgan Forward IndexesCredit CDX IndexesEmerging JP Morgan EMBI Global

*Can be specified as duration of % of index


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Overnight Cash3-Month1-Year

2-Years +/- 10% 5-Years

10-Years +/- 15% 20-Years30-Years +/- 10% 40-Years50-Years

TotalUSD: +/- 35%, all developed market term

structures permitted +/- 1 year -OR-

Average Duration

Currency USD: +/- 20%, All developed market currencies permitted +/- 20%

Investment Grade Minimum rating: BBB, Range: +/- 2 yearsHigh Yield Minimum rating: CCC, Range: +/- 1 yearEmerging No local currency exposure, Range: +/- 2 years

1-Day U.S Treasuries, custodial sweep accounts1-Week U.S Treasuries only1-Month U.S Treasuries, foreign government bonds

3-Months Government bonds, LIBOR-based AAA rated bonds





Once the benchmark has been speci ed in the Beta Exposures template, attention can turn to active portfoliomanagement, assuming that the pursuit of return above the benchmark is desired. Guidelines are generally expressedas permitted deviations from beta exposures and permitted classes of investments. Naturally, a passive mandate can

be de ned using the results of the previous section.

Acceptable deviations from benchmark exposures in four broad categories are determined in conjunction with the

investment manager. These should re ect the skill set of the manager, the con dence one has in these skills, thedesired level of relative risk versus the benchmark, and the investment horizon. Illustrated below are guidelines for asample core-plus mandate where the core is the simple liability benchmark described earlier.


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SummaryThese templates can be valuable tools for translating investment objectives into speci c terms that managers canuse in establishing portfolios that capture the purpose of their clients bond portfolios. They provide parameters thatde ne the various risks that can be taken and document the business elements of the investment mandate. Theseshould be used as exible tools, adapted as needed, to insure alignment of a clients expectations, portfolios returncharacteristics, and manager incentives.

III. Account StructureThe nal step in the process involves de ning the investment universe, setting performance objectives, and establishingthe fee structure. For the illustrative core-plus mandate, examples of typical parameters are shown in the followingexhibit.

III. Account Structure

Derivatives permittedNo: Equities, municipal bonds, convertibles

Counterparties rated A or better, maximum 10%Co-mingled funds require look-through

Excess Return 150 basis points, annuallized, net of feesInformation Ratio 0.4 to 0.8

Tracking Error 150 to 300 basis pointsHorizon Rolling 5 years

20 basis points-Plus-

Base 25% of excess or return over beta, net of base fee-Plus- and net of 3-month LIBOR;

Incentive subject to high water mark

Investment Universe

Performance Objectives

Fee Structure

Disclaimer: The views expressed herein are those of William Nemerever and are subject to change at any time based on market and other conditions. This isnot an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for il-lustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Copyright 2010 by GMO LLC. All rights reserved.

Mr. Nemerever is a co-manager of GMOs global xed income team.

new bond world management

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