GMO

WHITE PAPER
August 2010

New World Bond Management:

A Practical Framework for Decision Making
Bill Nemerever

Setting the Stage

On 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 firm and the internal investment
team was interested in starting with a clean slate, free from the biases and legacies embedded in their current fixed
income allocation. Usually these meetings are oriented around a product the bond manager wants to sell, rather than
one that might meet a client’s needs. We have some strong opinions about the proper way to think about fixed income.
Previous GMO white papers, What Should You Pay for Alpha? and Bond Benchmark Baloney, have highlighted our
observations on some of the market’s peculiarities with respect to the pricing of added value (alpha), and in the choice
of bond benchmarks. This paper is an attempt to answer the question of how to structure a bond portfolio in more
depth, 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 fixed income, and the pursuit of related alpha, is
most often done in a fairly conventional fashion, negatively influenced by many of the common misconceptions that
surround the asset class. We believe that the appropriate starting point must be to answer the question, “What purpose
do I expect my allocation to fixed 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 deflation or inflation.
■ Obtain foreign bond and currency diversification.
■ Provide a source of liquidity.
The following illustration is a light-hearted characterization of our view of today’s world of fixed income.
GMO 2 New World Bond Management – August 2010
 Why Own Bonds?
Naturally, there are a variety of reasons for owning bonds, not all independent of each other, and they are primarily
related to risk control. (Note that adding value through active management is not usually one of the responses.) Once
the reasons for owning bonds have been identified, the next step is to establish benchmark and investment approaches
that 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 and
communicating clearly with investment managers.
The role a bond portfolio plays varies from sponsor to sponsor, and meaningfully depends on its interaction with the
other asset classes represented. This paper is not intended to prescribe specific solutions or stray beyond fixed income,
but is meant to highlight the issues involved and provide a practical approach to translate the answer to the question
“Why own bonds?” into an effective portfolio.

Diversification
Bonds 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 is
easy to get enmeshed in the details of a bond mandate and lose sight of the need to address the desired level of
diversification.
In practice, how do typical bond portfolio allocations fare when the going gets rough on the equity seas? In a serious
equity 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 determine
with much precision, but some worst-case scenario analysis is useful in gauging the utility of varying degrees of
diversification. As an illustration, we’ve chosen to look at the 30-year period beginning with 1980, selecting the
quarters characterized by negative returns of the S&P 500. These are displayed in Exhibit 1 and are sorted from most
to least severe.

Exhibit 1
Total Return
S&P 500
Quarterly 1980 – 2009

5%

0%

-5%

-10%

-15%

-20%

-25%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83

Source: GMO, Barclays

New World Bond Management – August 2010 3 GMO

An effective bond portfolio hedge should offset a significant portion of the equity losses. For our illustration (see
Exhibit 2), we picked a dramatically simplified 75% stock/25% bond asset mix allocated between the S&P 500 and
the 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 serious
equity market declines. The 25% allocation to the Barclays Aggregate, shown in green in the following chart, does
little 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 2
Total Return (75% Stock/25% Bond)
S&P 500, Barclays Aggregate and Government/Credit Bond Indexes
Quarterly 1980 – 2009

10%

5% Barclays Long U.S.

Government/Credit Barclays Aggregate

0%

4Q07 2Q08

-5%
3Q08
1Q08
1Q09
-10%
S&P 500

-15%
Recent Equity Bear Market
4Q08 4Q07 through 1Q09

-20%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83
Source: GMO, Barclays

The portfolio returns corresponding to this 75/25 allocation are shown in Exhibit 3, making the point that such a
limited bond exposure provides little protection in difficult equity markets. Notably, in the most recent bear market, a
typical 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 first quarter of 2009, the Long U.S. Government/Corporate component of the Barclays Aggregate actually
declined along with the stock market. More distressingly, for the recent bear equity market period extending from
4Q07 through 1Q09, the 46% decline in the S&P 500 was offset by only a 6% return for the longer-dated component
of the Barclays Index.
While bond returns are generally negatively correlated with falling stock prices, it’s clear that higher fixed income
allocations 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 asset
allocation.

GMO 4 New World Bond Management – August 2010

 Exhibit 3
Total Return (75% Stock/25% Bond)
S&P 500, Barclays Aggregate and Government/Credit Bond Indexes
Quarterly 1980 – 2009
10%

75% S&P 500/25%

5%
Barclays Aggregate

0%
4Q07
2Q08

-5% 75% S& P 500/25%

1Q08 3Q08
Barclays Long U.S.
Government/Credit
-10% 1Q09

-15%
4Q08
Recent Equity Bear Market
4Q07 through 1Q09

-20%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83
Source: GMO, Barclays
Exhibit 4
Total Return (25% Stock/75% Bond)
S&P 500, Barclays Aggregate and Government/Credit Bond Indexes
Quarterly 1980 – 2009

10%
Barclays Long U.S.
Government/Credit
5%
Barclays Aggregate

0%
4Q07 2Q08
1Q08 3Q08
-5% S&P 500
1Q09
4Q08

-10%

-15% Recent Equity Bear Market

4Q07 through 1Q09

-20%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83

Source: GMO, Barclays

New World Bond Management – August 2010 5 GMO

Clearly, a dramatically larger allocation to bonds provided a significantly more effective offset to negative equity
returns than our previous 75/25 example, as illustrated by the chart of portfolio returns shown in Exhibit 5.
Exhibit 5
Total Return (25% Stock/75% Bond)
S&P 500, Barclays Aggregate and Government/Credit Bond Indexes
Quarterly 1980 – 2009

10%

5% 25% S&P 500/75%

Barclays Aggregate

0% 4Q07
1Q08 2Q08
4Q08

-5% 25% S& P 500/75%

3Q08
Barclays Long U.S.
1Q09 Government/Credit
-10%

-15%
Recent Equity Bear Market
4Q07 through 1Q09

-20%
4Q87
4Q08
3Q02
3Q01
3Q90
2Q02
1Q01
1Q09
3Q81
3Q98
1Q08
3Q08
4Q00
1Q82
3Q96
3Q99
1Q80
3Q85
1Q94
4Q07
1Q03
1Q90
2Q08
2Q00
2Q84
1Q92
1Q84
2Q81
1Q05
3Q04
2Q82
2Q06
3Q00
2Q91
3Q83
Source: GMO, Barclays
Note that the longer-duration benchmark provided somewhat stronger protection against a falling equity market in the
fourth quarters of 1987 and 2008, while the Barclays Aggregate came up a bit short. However, even if interest rates
fall 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, it
makes sense to consider a benchmark with a stable target duration implemented using non-callable, government
bonds, or associated derivatives.
It’s worth noting that the past 30 years hosted a significant decline in long-term interest rates, producing strong bond
market 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 bond’s sensitivity to changes in interest rates is increased.
Naturally, employing bonds as a hedge against significant equity losses requires a continuing assumption that the
returns of the respective asset classes will be negatively correlated as risk aversion rises.

Hedging Specific Liabilities

Nailing down the specific reasons for holding fixed income makes benchmark selection a lot easier. Endowments
and 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 financial footnotes to balance sheets and
income statements. Bonds are almost perfect vehicles for hedging nominal liabilities. Once it has been determined
how much of a hedge is desired, a plan’s actuaries can provide a schedule of specific risk-free interest rate exposures
to serve as a benchmark. Exhibit 6 shows an example of a portfolio of interest rate swaps designed to match a portion
of a European industrial company’s liabilities.

GMO 6 New World Bond Management – August 2010

 Exhibit 6
Barclays Capital Swap Index Liability Benchmark

Maturity
(Years) Weight
1 -1.8%
2 -0.1%
5 4.1%
10 12.1%
20 21.5%
30 41.3%
40 18.0%
50 4.9%
100.0%
Liability Value €245 million
This benchmark is straightforward and inexpensive to implement with interest rate swaps. The fact that it can be
easily replicated reduces tracking error, increasing the reliability of the hedge. Of course, the use of derivatives adds
complexity related to margin posting and collateral investment. In addition, the level of counterparty risk must be
weighed against the benefits offered by these instruments. Although more capital intensive, a portfolio of bonds with
similar interest rate and currency exposures can also provide an effective hedge. If liabilities are specified in real
terms, inflation swaps or inflation-linked bonds are natural vehicles to use. The hardest part of this exercise is deciding
how much exposure to hedge, not the mechanics of structuring the portfolio.

Deflation/inflation Protection
In the case of providing protection against inflation or deflation, as with equity diversification, an attempt must be
made to quantify the desired portfolio response. If inflation falls (or rises) by x%, what return is expected from the
fixed income assets?
Protection can be obtained through the use of bonds or derivatives. Their effectiveness naturally depends on how
closely their returns are correlated with changes in the price level one wants to hedge. Generally, hedging instruments
reference the most common measures of inflation at the consumer or national level. If the category of prices to be
hedged differs meaningfully from those referenced by popular indexes such as the broad CPI, alternative approaches
should be considered. Naturally, the closer the correlation between the risk one is trying to offset and the instruments
chosen to structure the hedge, the better the outcome. In certain cases it will be necessary to choose investment
vehicles that provide only moderate or loosely-correlated protection, or consider a customized over-the-counter bond
or derivative, which may prove to be quite expensive.
Inflation-linked bonds, interest rate swaps indexed to inflation/deflation, total return swaps, and bond futures provide
low-cost and effective means of delivering custom-tailored solutions. Derivative instruments are not cash-intensive,
so a relatively small proportion of portfolio assets needs to be allocated to do the job. Naturally the issues of margin
posting and collateral investment raised earlier apply here as well. Tailored instruments to hedge unusual risks are
likely to be expensive, inflexible, and illiquid, but their benefits may overcome these drawbacks.

Foreign Bond and Currency Diversification

Foreign bonds are efficient vehicles for gaining exposure to non-domestic interest rates and currencies. The universe
of developed market sovereign bonds is broad enough to provide the tools to obtain very specific interest rate and
currency exposures. Additionally foreign bonds can be employed to gain exposure to credit risk—sovereign, quasi-

New World Bond Management – August 2010 7 GMO

 sovereign, agency, multi-national, or corporate. Of course, interest rate and currency exposures can also be acquired
using 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 inflation rates or fiscal instability, will cause
them to diverge. Foreign interest rate and currency risks, to the extent that they are independent of their counterparts
in an investor’s home market, will diversify portfolio returns. Foreign bonds are also well-suited to hedging liabilities
denominated in foreign currencies and/or tied to foreign term structures and/or inflation.
Again, the specific exposures to foreign bonds and currencies can be inferred from the answers to the question of what
type and degree of diversification is desired.

Liquidity
Traditionally, investment-grade bonds have been a reliable source of liquidity. Naturally, shorter-dated government
and 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 fixed income markets in 2008 dramatically altered everyone’s perception of
liquidity. Market participants learned that off-the-run U.S. treasury bonds and inflation-protected notes can at times
become impossible to sell, except at fire sale prices. The crisis brought into focus the need for explicit liquidity
guidelines. Potential cash withdrawals over a specific 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 specific the
communication of liquidity preferences in various economic scenarios, the less chance there is for problems when
acute cash needs arise. Naturally, objectives must be consistent with the liquidity inherent in the chosen benchmark.

Beta Benchmark
The next step in the process is to turn the answers to the question of what role fixed income should play into an
investable benchmark. In some instances, such as the hedging of nominal liabilities, the benchmark is relatively
easy to establish. In others, such as diversifying equity returns, it is somewhat more difficult. Assumptions must be
made about the correlation of the benchmark portfolio and the risks to be hedged. Scenario analysis can be useful in
structuring benchmark portfolios in situations where the correlations are meaningfully below one.
In the case of equity diversification, 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 generalized
approach, incorporating some assumptions, provides a way forward. It is very important to define the period over
which the hedge is expected to provide protection. The example below assumes a quarterly horizon. Of course, the
benefits of diversification tend to diminish as the horizon lengthens.
Say one wishes to offset a third of the S&P 500’s losses in any quarter by positive bond market portfolio returns. As
a very simplified example, assume that, in falling stock markets, the Barclays Long U.S. Government/Credit Index
produces positive returns equal to half of the equity market’s quarterly decline (this is a rough approximation of the
relationship observed over the 30-year period ending in 2009 in calendar quarters when the S&P 500 declined). The
following 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

GMO 8 New World Bond Management – August 2010

 In this case then, an allocation of $100 to the S&P 500 accompanied by a $67 allocation to the Barclays Index (roughly
a 60/40 allocation) could be expected, on average, to produce approximately the degree of protection desired, provided
our assumptions are in the right ballpark. Of course, an even longer-duration bond portfolio would be less capital
intensive 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 in
the charts discussed earlier, quite variable. A more reasonable way of addressing the issue is to examine the changes
in interest rates that accompany falling stock markets and establish a government bond benchmark with a duration
calibrated to produce the desired result. While there are many ways to approach this problem, the important point is to
define the risks to be diversified, 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 hedged
and hedging assets – equities and bonds – is somewhat uncertain. Of course, the more “bond-like” the purpose of the
fixed income allocation, the more effective bonds will be in fulfilling it. Again, a good example of a nearly perfect fit
is 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 the
objectives for the bond portfolio and the availability of market instruments whose returns are highly correlated with
the objective. However, the lack of perfect hedging vehicles should not dissuade one from structuring a bond portfolio
to 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 fixed income investing are interest rate risks. Given
the broad array of developed markets interest-rate derivatives, market exposure can be achieved with relatively little
cash commitment. Most of the change in a bond’s price can be explained by changes in the government bond term
structure of interest rates in the country in whose currency the bond is denominated. Thoughtful incorporation of these
risks in the benchmark should be the primary focus.
The issues highlighted above can be used to organize the process of producing more specific 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, specific structural sensitivity to various sectors, such as investment-grade credit, can easily be incorporated
without compromising the primary reason for holding bonds.
Obviously, there are many trade-offs, and perhaps conflicting objectives, that must be balanced. However, without
some specificity at this stage, constructing a thoughtful bond portfolio is more or less left to chance. An investment
consultant can be very helpful in highlighting the various scenarios and finding reasonable and practical solutions.

The Alpha Portfolio

Once the basic benchmark is in place, attention can be focused on adding value to its return from active bond and
currency strategies. Importantly, active strategies must be employed in a way that doesn’t dilute significantly the
chances of realizing the primary objective of the fixed 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 an
unimpaired ability to meet margin calls, especially during a liquidity crisis like that experienced in 2008. Although
there is generally no compelling financial reason to connect these active strategies with the benchmark, many find
this a more understandable and acceptable structure. Realistically, though, the selection of active bond and currency
strategies should focus on:

New World Bond Management – August 2010 9 GMO

■ How much confidence does one have in the manager?
■ What market inefficiencies 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 generally
adds to risks embedded in existing portfolios is much less valuable than one that is truly different. For example, a
high-yield, credit-based fixed income strategy may be highly correlated with equity market returns. It’s best to avoid
paying alpha-based fees for beta risk, especially when more of that specific risk is not desirable. An alpha process
that has low correlation to both beta exposures and other value-added strategies can be a meaningful contributor to
portfolio efficiency, adding another dimension to excess returns.
Although active fixed income strategies are generally embedded in the fixed income allocation, their selection and
sizing should be part of the total alpha allocation process.

Conclusions
The 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 designing
a benchmark that maximizes the likelihood of meeting them. Of course, the role of bonds must be viewed in the
context of the total plan asset allocation. The issues discussed in this paper are clearly a subset of the broader asset
allocation 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 them
on, the beta portfolio; and establishing realistic risk tolerances. When bond mandates are assembled in this fashion,
communication with the manager is well-defined and the primary purpose of owning bonds is not compromised by
poorly conceived benchmarks or excessive active risk.

GMO 10 New World Bond Management – August 2010

 Appendix:
A Template for Organizing Decisions
In this appendix we provide a framework for:
I. Converting fixed income asset class objectives to specific benchmark (beta) exposures,
II. Specifying active management guidelines with respect to the benchmark, and
III. Defining the structure of the mandate with respect to investment universe, performance objective, and
incentive fee structure.
The following exhibit is a generalization of the template to be used to guide decisions made with regard to these three
elements of a fixed income mandate.
Investment Management Template

I. Beta Exposures II. Active Management Guidelines

Term Structure (Nominal or

Inflation-Linked)

Currency

Credit Duration* (May be

static or dynamically set as a
function of relative valuation)

Cumulative Liquidity

III. Account Structure

Investment Universe

Performance Objectives

Fee Structure

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

New World Bond Management – August 2010 11 GMO

I. Beta Exposures
As expressed earlier, the process must begin with a fairly specific expression of what the expectations are for the
bond portfolio allocations. Of course, the more definitive the expectation, such as, “I want to match my retired life
liabilities,” the more precise the benchmark. And, the more the expectations are related to nominal interest rates, the
more effective a portfolio of nominal bonds will be. Of course there are many other “fixed income” instruments such
as index-linked bonds and total return swaps that can be employed in the specification of a suitable benchmark. The
important objective is to craft a benchmark that can be replicated in an acceptable fashion using available financial
instruments.
Defining expectations is the most difficult step in the process since the inability to be specific about one’s 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 30
years.
Risk exposures may be specified in four dimensions. Note that these exposures are independent of the instruments
used to achieve them.
1. Term structure, the most important factor, defines the exposure to risk-free interest rates, nominal or real. The
specification format is flexible enough to accommodate a detailed liability-based objective, or can be defined
simply as average duration. Exposure can be broadened to foreign term structures.
2. Currency exposure can be entirely in the home currency or distributed more broadly.
3. Credit duration can be specified for investment grade corporate bonds, high yield corporate bonds, and/or emerging
country debt. If more useful, the benchmark exposures to these credit sectors can be expressed as percentages of
market value invested in referenced indexes.
4. Cumulative liquidity preferences are expressed in a table listing, for both a normal and “stressed” environment,
the percentage of account assets that can be sold, in the required time frame, at or near current valuations.
All beta exposures are specified in terms of investable indexes or instruments.

GMO 12 New World Bond Management – August 2010

 I. Beta Exposures
U.S. Euro U.K. Japan Canada
Overnight Cash
3-Month
1-Year
2-Years 15%
5-Years
10-Years 45%
Term Structure (Nominal or 20-Years
Inflation-Linked) 30-Years 40%
40-Years
50-Years

Total 100%

-OR-
Average Duration

Currency 100%

Credit Duration* (May be Investment Grade 1.5 years

static or dynamically set as a High Yield 2 years
function of relative valuation) Emerging 1 year

Normal Stressed
1-Day 10% 5%
1-Week 25% 13%
Cumulative Liquidity
1-Month 50% 25%
3-Months 90% 70%

Beta References
Term Structure Barclays Index Swaps
Currency JP Morgan Forward Indexes
Credit CDX Indexes
Emerging JP Morgan EMBI Global
*Can be specified as duration of % of index

New World Bond Management – August 2010 13 GMO

II. Active Management Guidelines
Once the benchmark has been specified in the Beta Exposures template, attention can turn to active portfolio
management, assuming that the pursuit of return above the benchmark is desired. Guidelines are generally expressed
as permitted deviations from beta exposures and permitted classes of investments. Naturally, a “passive” mandate can
be defined 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 reflect the skill set of the manager, the confidence one has in these skills, the
desired level of relative risk versus the benchmark, and the investment horizon. Illustrated below are guidelines for a
sample “core-plus” mandate where the “core” is the simple liability benchmark described earlier.

II. Active Management Guidelines

Overnight Cash
3-Month
1-Year
2-Years +/- 10%
5-Years
10-Years +/- 15%
Term Structure (Nominal or 20-Years
Inflation-Linked) 30-Years +/- 10%
40-Years
50-Years
USD: +/- 35%, all developed market term
Total
structures permitted +/- 1 year
-OR-
Average Duration

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

Currency permitted +/- 20%

Credit Duration* (May be Investment Grade Minimum rating: BBB, Range: +/- 2 years
static or dynamically set as a High Yield Minimum rating: CCC, Range: +/- 1 year
function of relative valuation) Emerging No local currency exposure, Range: +/- 2 years

1-Day U.S Treasuries, custodial sweep accounts

1-Week U.S Treasuries only
Cumulative Liquidity 1-Month U.S Treasuries, foreign government bonds
3-Months Government bonds, LIBOR-based AAA rated bonds

GMO 14 New World Bond Management – August 2010

 III. Account Structure
The final step in the process involves defining the investment universe, setting performance objectives, and establishing
the fee structure. For the illustrative “core-plus” mandate, examples of typical parameters are shown in the following
exhibit.

III. Account Structure

Derivatives permitted
No: Equities, municipal bonds, convertibles
Investment Universe
Counterparties rated A or better, maximum 10%
Co-mingled funds require look-through

Excess Return 150 basis points, annuallized, net of fees

Information Ratio 0.4 to 0.8
Performance Objectives Tracking Error 150 to 300 basis points
Horizon Rolling 5 years

20 basis points
-Plus-
Base 25% of excess or return over beta, net of base fee
Fee Structure -Plus- and net of 3-month LIBOR;
Incentive subject to high water mark

Summary
These templates can be valuable tools for translating investment objectives into specific terms that managers can
use in establishing portfolios that capture the purpose of their clients’ bond portfolios. They provide parameters that
define the various risks that can be taken and document the business elements of the investment mandate. These
should be used as flexible tools, adapted as needed, to insure alignment of a client’s expectations, portfolios return
characteristics, and manager incentives.

Mr. Nemerever is a co-manager of GMO’s global fixed income team.

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 is
not 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.

New World Bond Management – August 2010 15 GMO