Do retirement savers need to adjust their fixed income allocations?

next issue no. 10: Investment corner

Fixed income normally has a relatively consistent role in retirement accounts, especially target date funds. It is a conservative allocation that generates income, and sits opposed to equities, which are designed to have more capital appreciation and be higher risk.

But, as we covered in our last edition of next, this year has seen elevated levels of volatility across multiple asset classes. With the U.S. Federal Reserve hiking rates at an unprecedented rate fixed income price returns have been severely impacted. As such fixed income returns have been broadly negative alongside equities, despite elevated yields.

With our macroeconomic call for a mild recession next year, we also expect spreads to widen and defaults to marginally climb as more troubled companies are unable to refinance their debt at the yield levels that are now demanded by the market.

So, what does this mean for the ongoing role of fixed income in retirement plans? And what questions should plan sponsors be asking of their asset managers to make sure that they are properly positioning for an environment that hasn’t really been seen since the mid-1990s.

Yields are very attractive now

One thing that has to be stated early, and will occur throughout our commentary on fixed income, is that yields are now at levels that are very attractive for asset allocators. It was not long ago that we were diving into our asset allocation models to calculate the exact mixture of public and private assets, and below investment grade corporate debt or structured products, that were needed to bring a portfolio’s yield up to 4/5% levels.

Now? U.S. Treasuries are essentially good enough if a simple yield target is all an allocator needs. The Bloomberg U.S. Aggregate Index, a common broad fixed income benchmark with a majority allocation to Treasuries, currently yields over 4.5%.

While most retirement portfolios should be focused on relatively lowrisk sectors within fixed income, again to focus on income generation and to try and insulate the portfolio from future volatility. There is definitely an argument to be made that a fixed income asset management team that is able to stretch slightly across fixed income asset classes, perhaps with an allocation to preferred securities or to even just higher quality corporate debt, could gain even higher levels of yield.

We also believe that interest rates will be range-bound in the near term before declining in the second half of 2023, and we forecast that risk premiums may widen further over coming quarters, providing an even more attractive entry point.

But what about the recession?

However, our base case, as outlined in our 2023 GIC outlook, is that if the U.S. enters a recession in 2023, it should be relatively mild. The economic growth outlook faces higher uncertainty and stronger headwinds than it has in recent years, but fundamentals are ultimately supportive and will help the U.S. economy avoid a deep recession. The underlying strength of the consumer remains a firm positive for the economy and should help insulate much of the economy from a more severe downturn brought on by tighter financial conditions.

We do see a risk that sharply reduced monetary and fiscal policy support will reduce growth and inflation in coming quarters. Overall though we expect the 10-year Treasury yield to end the year around 3.75%.

When examining the corporate bond market, we do not expect defaults to rise to levels seen in more severe recessions, partly because corporate interest coverage ratios remain at surprisingly elevated levels.

So, despite the higher cost of financing that will hit most corporate balance sheets as debt comes due, we believe that many companies are in a robust enough state to be able to weather the storm.

Therefore, over the medium term, we expect that strong fundamentals will help limit the damage to spread sectors and we favor a modest overweight to IG credit and the higher quality segments of high yield, floating-rate loans and preferreds.

We also believe that both the dollar and longterm interest rates have peaked for this cycle, as the market increasingly looks forward to future economic weakness and eventual rate cuts.

Positioning fixed income in 2023

There will be attractive entry points for emerging markets and long-duration assets in the quarters ahead. And while emerging markets may not be particularly suitable as a significant allocation for a portfolio focused on target date liabilities, it could still be useful if the underlying asset manager has the capacity to reach into more esoteric fixed income asset classes as ultimately diversification remains critical.

We believe that a portfolio with a focus on credits with durable free cash flow and solid balance sheets across a wide range of sectors is a robust approach through an economic downturn. Diversified strategies with higher rate sensitivity look attractive. We expect to increase risk in our fixed income portfolios over coming quarters as valuations improve.

The duration positioning of a portfolio is another consideration. While we have been generally short duration over the last year, we are now starting to move further out along the curve. Especially for investors that focus on buy-and-hold strategies simply moving further out on the duration curve to the 7–10-year part of the corporate market could bring yields over 5% without taking on significant additional risk.

If an investor is positioned in higher quality investment grade bonds, while there may be some negative price returns through a recession, it would be possible to hold the bonds to maturity almost regardless of the underlying economic situation and to see significantly higher yields than would have been possible across much of the last decade.

What to ask your fixed income asset manager

In this peculiar environment, with higher yields a very tempting place to park assets, while at the same time recession risk looms, it might be worth asking your fixed income asset manager some questions as to how they view both the macroeconomic environment and their underlying portfolio positioning.

1. Are your fixed income managers adequately allocated to pick up the yield of the underlying Aggregate Index, targeting high quality Treasuries and some corporate exposure, or are they stretching into noncore allocations to pick up additional yield?
2. Do your managers have sufficient flexibility and cash allocations to effectively allocate within and across fixed income sectors as rates change through this relatively uncertain environment?
3. Are the target date fund portfolios appropriately exposed to duration?
4. Do your fixed income managers have a track record of high upside capture and low downside capture ratios?
5. Do your managers have the experience, resources, scale and market presence to manage fixed income assets effectively in all market environments?