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Do retirement savers need to adjust their fixed income allocations?

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.

Income as a portion of total return
Yield to worst by fixed income sector

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.

Corporate interest coverage ratios

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.

In this issue
Retirement Longevity literacy promotes understanding the need for lifetime income
The TIAA Institute-GFLEC Personal Finance Index continues to be a significant resource in examining financial literacy levels among U.S. adults and how that relates to their financial well-being, including retirement readiness.
Retirement ESG in retirement plans: Clarity but no certainty after DOL ruling
As we discussed in an edition of next last year, there were a number of key themes that we were looking for in the upcoming DoL ruling on the implementation of ESG in retirement plans.
Retirement SECURE Act 2.0: Our top four most anticipated provisions
We’ve been watching the development of the new law through various House and Senate committees, and we examine our top provisions and the impact we look forward to them having.
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The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her financial professionals.

Please note that this information should not replace a client’s consultation with a tax professional regarding their tax situation. Nuveen is not a tax advisor. Clients should consult their professional advisors before making any tax or investment decisions.

Nuveen provides investment advisory solutions through its investment specialists.

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