Is Fixed Income Working?
Art by James Yang
The current state of the fixed-income markets presents a puzzle to participants, plan sponsors and advisers. According to conventional thinking, people saving to fund their retirement should shift their emphasis from stocks to bonds as a way to reduce risk and to generate a higher level of income to live on, observes Tim Swanson, chief investment officer (CIO) of Compass Financial Partners LLC, an advisory firm headquartered in Greensboro, North Carolina. “In this environment, though, with interest rates so low, there’s an argument to be made that fixed income is not fulfilling either of those roles,” he says.
Interest rates are cyclical creatures, and at some point they are likely to stand far higher than they do today. But the accompanying chart demonstrates the dark side of the cycle, plotting the yield of the 10-year Treasury note from 1962 through the present. In 34 of those 57 years, the 10-year yielded above 5% although for only a few select months in the current century, the last one being July 2007. Today, it trails inflation, at about 1.5%.
10-Year U.S. Treasury Note Yield, Monthly Average
(1962 – 2019)
Older participants seeking to avoid the volatility of equities need to invest somewhere, and, in a retirement plan context, the only viable option is fixed income. Bond vehicles suitable for defined contribution (DC) plans come in many varieties: domestic or international; short term or long term; safe or speculative. For investors dedicated to target-date funds (TDFs), managers handle the tough questions of maturity and risk, as well as the transition through time.
Within the fund lineup, most plans provide a stable value or money market option, with short maturities and yields to match but little risk to principal. Also prevalent are funds following core strategies tracking the Bloomberg Barclays Aggregate U.S. Bond Index, a broad range of government and corporate bonds, all of high quality. Core plus strategies cast the net more widely, to capture the higher expected risk and return of high-yield corporate or emerging market bonds.
“Generally, we’ve found that active managers in fixed income can extract greater value net of fees, versus equities,” notes David O’Meara, head of defined contribution (DC) strategy at consultants Willis Towers Watson in New York City.
Advisers also report considering global bond funds—or not—to round out the opportunity set. “We have some plans with global bond funds, but with $15 trillion of bonds around the world with negative yields, that doesn’t strike me as a fantastic environment,” Swanson says. Likewise, he sees stand-alone high-yield corporate bond funds as a “sharp option,” having a level of risk many participants might not grasp.
Granted, few observers are calling for higher interest rates anytime soon or offering a plausible scenario for how rates would rise. But in the event that they do a few years out, how should advisers guide sponsors in stocking the shelves in the fixed-income aisle?
“The market today is not the only one we’ll see over five years, so it’s a good time for fiduciaries and their advisers to evaluate whether the menu offers the breadth and choice to weather all sorts of markets,” O’Meara says. “We may need to offer investments that might not look so attractive today—five years ago, sponsors were offering money market funds that were yielding zero. But today, many are paying 2% and serving as a store of wealth while keeping pace with inflation.”
“If rates are rising, there is likely some inflation driving that, so you would want some inflation protection, too, through TIPS [Treasury inflation-protected securities],” notes Chris Dillon, investment specialist in the multi-asset division of T. Rowe Price Group Inc., in Baltimore. “But they should be short in duration—it’s our view that TIPS, beyond five years, bring interest rate sensitivity that you don’t want.”
“[Plans] want to offer enough flexibility in the fixed-income menu to allow participants to capture higher rates and keep capital preservation a priority,” observes Ed McIlveen, director of research at Francis Investment Counsel LLC, in the Milwaukee suburb of Brookfield. “First, a stable value option is key. Second, include an option that is very safe—we have a lot of clients that use TIPS. Then you should have an intermediate-term core bond fund and one for emerging-market debt. With those four categories, participants can build a fixed-income portfolio that has sensitivity to rising rates and inflation, and there will be enough income to compensate for the credit risks they are assuming in the corporate and emerging markets.”
McIlveen thinks the best preparation sponsors can make for higher rates is to line up retirement income opportunities: “They are in their infancy, but there are marketplaces for annuities, where a participant can get a quote from five or six insurance companies at institutional prices. Participants should be able to pull that lever when rates are higher and annuity pricing makes sense.”
A more complex fixed-income lineup requires education enabling participants to understand what suits them best. “I have yet to go to a cocktail party where fixed income is the prime topic—equities get all the airtime,” observes David Zee, a specialist on fixed income at consulting firm Callan LLC in San Francisco. “It’s about giving participants an appreciation of the benefits. Older participants might be looking for a counterbalance to equity volatility, while younger workers might be looking for the additional expected return from core-plus strategies. People also need to know how they can use the different options to achieve their retirement income.”
“We tell participants that bonds are like stocks, in that they are all different, and have a purpose in a diversified portfolio,” says James Battmer, chief investment officer at Resources Investment Advisors, in Overland Park, Kansas. “They have to think of fixed income as an anchor and accept that, over the long run, it will probably be the worst-performing component of the portfolio but that it operates as insurance.
“And people should not be disappointed when it earns 0%, as bonds did in 2018,” he adds. “Many got rid of their bonds at the exact moment they shouldn’t have.”
Until that sunny day that interest rates are high enough to pay a generous income to DC retirees, Battmer sees further trouble. “Our industry is on the brink of a retirement crisis, because so many target-date funds are built on the assumption that fixed income can still generate significant real returns. When we don’t have the 60% of the portfolio creating returns of 6% or 7%, fixed income is no longer the buttress it used to be, and, for those people who are in and near retirement, that’s a danger.”