Prolonged Low Rates and TDFs
Anne Lester, portfolio manager and head of retirement solutions at J.P. Morgan Asset Management, says the prolonged low interest rate environment has caused significant challenges for retirement plan investors who own target-date funds (TDFs).
According to Lester, what a market observer can say today with confidence is that interest rates have remained at historic lows in the developed world. There is little indication that they will climb quickly, she says, and, at the same time, equity valuations are at the end of an 11-year bull market. Valuations are not extremely stretched, but they are certainly not in what Lester would call “super comfortable” territory.
“The question is, where do you put your money to work in an environment where rates are low and where inflation is low, as well?” Lester says.
J.P. Morgan’s current strategic orientation to fixed income is to avoid holding non-U.S. fixed income, aside from emerging markets, because her team thinks that sector has an unattractive risk-return profile, she says.
“You can just look at how much of the non-U.S. market has negative interest rates to see why we think this way,” Lester says. “So, from a strategic perspective, J.P. Morgan does not like non-U.S. investment-grade debt. A chunk of our allocation is to the Agg [Bloomberg Barclays U.S. Aggregate Bond Index], but, in our view, it’s very important not to just blindly own the Agg in passive ways.”
Lester says J.P. Morgan also believes in allocations to credit—both high-yield and emerging market debt.
“These asset classes are somewhat different from plain vanilla fixed income, in that you have some equity beta built into them, which gets expressed as spread duration,” she adds. “Our position overall is becoming more cautious on the equity markets and more cautious on some of our extended credit positions. We are maintaining an active position in fixed income because we need to be nimble.”
Like Lester, Scott Donaldson, a senior investment analyst in the Vanguard Investment Strategy Group, spends considerable time analyzing both TDF management decisions and the broader progress of the market. Working at Vanguard, which is known for its passive, index-based approach to retirement investing, Donaldson unsurprisingly has a somewhat different take on the best way to plot a course through this fixed-income environment.
Generally speaking, he says, Vanguard’s perspective is that the best approach to meeting clients’ objectives is to build an enduring glide path that can navigate the various difficulties that TDF investors inevitably face at different points in their savings journey. In practice, this means establishing what Donaldson calls “real diversification” in the setup of the weights of the asset classes that the participants are exposed to—and continually monitoring this strategy to make sure it still makes sense as the world evolves.
“In a low interest rate environment, trying to juice returns on the fixed-income side means moving into higher-yielding alternatives other than say, government debt or even investment-grade credit,” Donaldson says. “Greater return potential may be there, but there are tradeoffs to doing this. The pros, of course, are that, yes, you may get an increase in yield for a period of time. The negative tradeoff is significantly lower diversification for the whole portfolio and higher risk concentration. The more credit you get into, generally, the higher correlation your portfolio will have to the equity markets, should something go wrong.”
According to Donaldson, the fact that retirement plan fiduciaries are the ones making the decisions about which TDFs to offer is important to keep in mind throughout this discussion.
“Pursuing that higher level of yield makes sense for some people, but you have to be willing to gain the higher yield by having a higher concentration in similar types of securities—lower-quality bonds that are more correlated with equities,” he says. “This means that, if something goes significantly wrong, that extra 50 basis points [bps] you tried to squeeze out of the market may pale in comparison with the downside you could experience.”
In terms of specific holdings, Donaldson says, Vanguard believes strongly in the diversification potential of high-quality non-U.S. government bonds, and it invests accordingly. He freely admits these are actually even lower-yielding on a local basis than the U.S. fixed-income market.
“Instead of seeking higher-yielding instruments,” he says, “we feel that a strategic asset allocation of having non-U.S. bonds with another 30 or 40 countries represented is highly valuable even when their rates are low and even when those are, in some cases, negative.”