Fixed income in motion: don’t let your target date funds get left behind
The Federal Reserve (Fed) has been on a path toward normalizing interest rates from their all-time lows over the past three years, raising its benchmark rate a total of nine times since December 2015. While the Fed had indicated late last year that additional hikes were in the offing, recent stock market volatility, concerns about global growth and dovish comments from the Fed have made that path seem less clear, and it may be more data dependent. It continues to remain critical to review fixed income allocations in the context of an uncertain interest rate environment, and ensure that allocations in your plan’s target date funds are appropriate and responsive to changing rates over market cycles.
Fixed income: can’t live with it, can’t live without it
While we all know target date fund performance may benefit from allocations across multiple asset classes, the equity allocation tends to get the most attention because of the higher absolute return potential and higher volatility. But fixed income allocations serve a critical role by providing both an opportunity to mitigate risks and a source of excess return potential for participants.
For most target date funds, the role of fixed income shifts over the course of an investor’s retirement savings horizon. During early savings years, fixed income allocations typically emphasize yield generation with a degree of capital appreciation through exposure to credit-based fixed income securities. As an individual approaches retirement, the focus generally shifts to helping to manage risk, inflation and interest rate fluctuations.
How changing rates affect target date funds
Volatile interest rates, fluctuating fixed income valuations and risk premiums, along with the evolving credit cycle, may certainly warrant a fixed income menu review to reaffirm if existing investments can withstand the current or anticipated market environment. The same is true for target date funds. As a plan sponsor, you should understand how a target date fund’s fixed income allocation may perform in these shifting market conditions and how they can affect participant outcomes. There are four key areas plan sponsors should consider to keep their target date fund bond allocations on track:
Very often, target date funds tie their fixed income allocations to the Bloomberg U.S. Aggregate Bond Index (the Agg), but is the Agg really the optimal solution for participants? Although the Agg represents the largest issuers of debt and is composed of thousands of bonds, that doesn’t mean it’s well diversified across fixed income sectors. U.S. Treasury and other government-issued securities tend to be particularly sensitive to rising interest rates, and over the past decade the Agg’s concentration of U.S. Treasuries has increased from 25% in 2008 to 38% today (Figure 1). A number of the sectors excluded from the Agg, such as high yield and emerging markets debt, have historically held up best during periods of rising rates (see Figure 2).
A target date suite that overweights U.S. Treasuries and other government securities may prove positive in some market environments and negative in others. In our view, a more balanced fixed income strategy that strategically allocates to non-core fixed income sectors may be less sensitive to rising interest rates and offer potentially better returns from higher-yielding sectors, while helping participants weather the evolving fixed income environment.
2: Interest rate sensitivity
Participants nearing retirement are particularly sensitive to changing interest rates. That’s because target date portfolios for these participants are more conservatively positioned with higher allocations to fixed income. Because these participants are typically approaching the time they may need to make withdrawals from their accumulated savings, they have less time to recover from potential market volatility and resulting losses. How can plan sponsors help this vulnerable population?
Understanding the duration of your target date fund’s fixed income allocation is key. Portfolio duration is often seen as a primary measure of interest rate sensitivity. Funds with a shorter duration may prove more beneficial for certain participants in a rising rate environment, while funds with a moderate to high duration may be exposed to a higher degree of interest rate risk. It’s critical to understand your target date fund’s fixed income composition and related duration to help ensure the target date funds on your menu are aligned with the needs of your participant demographic.
3: Performance in up-and-down markets
As a plan sponsor, generating strong fixed income performance is obviously a key goal, but the ability to manage risk is just as important. This potential for downside protection is critical for target date funds, as many participants rely on the funds’ “set it and forget it” approach for allocating assets across long time horizons and varied market environments. To help drive positive retirement outcomes for participants, we recommend choosing a target date fund whose underlying fixed income funds have demonstrated the ability to both capture returns during up markets, and weather down markets. The next question is often, “How can that ability be measured?”
One place to start is by looking at the underlying funds that make up the largest portion of your target date funds’ fixed income portfolios for comparison. Next, determine those funds’ longer-term upside and downside capture ratios, which measure their performance relative to an appropriate benchmark — in this case, the Bloomberg U.S. Aggregate Bond Index — during periods of favorable and unfavorable market conditions. Plot those funds in the grid, based on those ratios (see Figure 3). Funds that fall in the top-left quadrant represent the most favorable combination: highest upside capture and lowest downside capture.
4: Portfolio manager skill and experience
In an evolving fixed income landscape, it’s a given that portfolio managers should have the experience and resources to allow them to capitalize on opportunities across markets, and that extends to the fixed income managers within a target date fund. The ability to generate performance through security selection, sector rotation, yieldcurve positioning, fundamental and technical analysis and trading are all hallmarks of a skilled fixed income manager.
For example, firms with management expertise across a variety of fixed income sectors, geographies and market environments can provide the scale, deep research expertise and access to capitalize on fixed income market inefficiencies. This is the type of fixed income expertise needed to support a successful target date suite.
Changing with the times
With professional management, diversified asset allocation and automatic rebalancing, target date funds can offer an effective investment strategy for a changing rate environment. But remember: not all target date funds are created equal. Some funds may be better positioned for certain market environments over others. You may decide that your current managers are not equipped to navigate the evolving fixed income landscape. If you are considering a change, we suggest asking the following questions when comparing managers:
- Does the manager have sufficient flexibility to effectively allocate within and across fixed income sectors as rates change?
- Am I appropriately exposed to duration across my target date fund portfolios?
- Do the fixed income managers have a track record of high upside capture and low downside capture ratios?
- Does the manager have the experience, resources, scale and market presence to manage fixed income assets effectively in all market environments?
While the interest rate environment may remain uncertain, fixed income will continue to play a vital role in your target date retirement strategy. That’s why it’s important to understand how your fixed income component can affect retirement outcomes for your participants, and ensure that it is positioned appropriately.