The Value of Fixed Income.
Art by Jenn Liv
While much attention is being paid to equity holdings, because the market has been delivering strong gains since the Great Recession, advisers need to make sure defined contribution (DC) plan sponsors include the appropriate fixed-income options in their investment lineups, and that defined benefit (DB) plan sponsors are using the appropriate fixed-income vehicles in their portfolios, as well.
Brett Wander, chief investment officer (CIO) for fixed income at Charles Schwab Investment Management in San Francisco, says, in a fixed-income environment where both interest rates and spreads are low and have stayed low, almost all sectors have been performing well. According to Wander, the concern is that interest rates will rise and bonds will underperform. However, “they have been performing well due to little interest-rate volatility, and there’s a good chance that will continue,” he says.
There is a sense among investors that, because the Federal Reserve is raising interest rates, rates will rise on longer-term bonds, Wander says, but actually, there is little relationship between rates rising on Fed funds and an increase in the yield curve. “The outlook is for bonds to continue to return in a stable way,” he notes.
For this reason, “even in a low-interest-rate environment, fixed income broadly makes as much sense as in a high-interest-rate environment. It’s a good hedge against equities if they underperform,” Wander says.
Many DB plan investors want to take a wait-and-see approach: They believe that interest rates will go much higher. But this has failed to materialize in the past, according to Jay Sommariva, vice president and senior portfolio manager at Fort Pitt Capital Group in Pittsburgh. He says, if DB plan investors want to get into fixed income, they should “ladder” investments into bonds to avoid having all their eggs in one basket. “They can invest additional money if rates go higher, yet already be somewhat invested if rates go down,” he says. He added that this is as good a time as any to invest in fixed income to lock in some equity gains.
Sommariva explains that having a laddered bond portfolio would be like investing 20% in bonds per year, so there is constantly a maturity date rolling off, and if interest rates go higher, investors can move out of the ladder and take advantage of those rates.
Jake Gilliam, senior multi-asset class portfolio strategist at Charles Schwab & Co. in Richfield, Ohio, says advisers working with plan sponsors should have conversations about being cautious and understanding the drivers of fixed-income performance, especially in active environments.
Wander illustrates why: Parts of the bond market, such as the corporate bond market, entail significant credit risk. Often, in a low-interest-rate environment, investors are compelled to find higher yields, so they choose high-yield corporate bonds, he says. “When they do that, they have taken on a greater risk of default, and they find themselves in investments that act like securities do.”
According to Gilliam, investors are tempted to go to managers that have outperformed, but risk can be masked in a low-interest-rate environment. If the markets turn, investors will fail to get the same outperformance. There needs to be full transparency of the sources of outperformance, he advises.
Evaluating Fixed-Income Vehicles
Sommariva notes that evaluating fixed-income vehicles is complex. He suggests, when a plan sponsor client wants to invest in a particular sector, the adviser look into that sector and find companies that are not highly leveraged, checking to see if they have a track record of paying back principal and interest.
Fort Pitt constantly monitors investors’ portfolios to see if a specific company in a sector within a portfolio makes an adverse move. Advisers can make the decision to remove that company, or to keep it if the company is expected to pay. “A constant monitoring of portfolios is required,” Sommariva says.
Gilliam says, when evaluating fixed-income options, advisers must first understand the plan sponsor client and its risk tolerance. For DB plans, advisers need to know the time horizon and goals for fixed-income investments. When evaluating specific fixed-income managers, he says, look beyond relative performance and get an idea of the type of risk the manager is taking. He suggests advisers be wary of active managers overweighting vehicles that do best in volatile markets--e.g., indexed and credit vehicles--because when the market changes, performance will be subpar. Gilliam also recommends using managers that are not necessarily at the top of the leader board. However, he says, do not switch out managers whose investments may have high volatility in performance once they perform better. Look at the underlying construction of investments to determine if they are worth the risk.
Managers generating the highest yield may well be the ones taking on higher risk, and those performing well now may become underperformers next year, Wander says.
When you assess fixed-income holdings in target-date funds (TDFs) for a DC plan, Gilliam says, the funds should start out with 5% in fixed income for participants in their early 20s, and, over time, as the participants approach retirement, the TDF should have a 60% allocation to broadly diversified fixed income. Then, in the five years preceding participants’ retirement, or once they have entered it, TDFs should switch from higher-risk fixed-income vehicles to cash and inflation-protected securities. “For a person in retirement, 75% in fixed income is a safe haven,” Gilliam says. “Plan sponsors don’t want participants to be worried their life savings is at risk, especially in retirement when they don’t have time to withstand market storms.”
The Vehicles That Are Best for Now
In its PGIM Fixed Income 4th Quarter Outlook, PGIM Inc. points to three asset classes it currently finds attractive: structured products, U.S. and European bonds, and emerging markets.
“High-quality structured products generally earned their carry in Q3,” the report says. “For example, the spreads on AAA tranches of CMBS [commercial mortgage-backed securities] and CLOs [collateralized loan obligations] finished the quarter basically unchanged. Range-bound spreads were consistent with our expectations, and this remains our base case in Q4. Our favorite picks continue to be AAA CLO and CMBS bonds.”
As for U.S. and European bonds, the outlook states, “[In] both the U.S. and Europe, we believe that spreads are at fair levels but have the potential to grind tighter in Q4 given the favorable fundamentals, ongoing investor demand for yield and minimal risk of a recession in the near term.”
The report goes on to say, the emerging market debt sector continued its solid performance in Q3, with all segments posting healthy returns. In the hard currency sovereign space, the higher-yielding issuers reported the highest returns, particularly El Salvador (9.7%), Belize (7.9%) and Suriname (7.06%). In addition, a number of countries returned more than 5%, including Argentina, Egypt, Ethiopia, Ghana, Iraq and Mozambique.
Wander suggests that instead of thinking about what sectors are attractive, advisers should think long-term and not overreact to current dynamics.
Specific to DC plans, Gilliam says, fixed-income investment menu options should include low-volatility and stable components. “Advisers should focus on making sure plan sponsors are not including high-risk options but very conservative and broader fixed-income options,” he says.
“We feel the single biggest mistake bond investors can make is to overreach for yield. The wisest thing is to focus on the long term and not make changes based on short-term variations in the market,” Wander concludes.
* A case can be made for including fixed income in a portfolio because interest rates are expected to remain low in the near future and bond returns are expected to remain stable.
* Bonds are viewed as a good hedge against equities, should the bull market come to a close.
* In the event that interest rates rise, bond ladders enable DB plan investors to take advantage of rising rates.
* Experts recommend advisers seek out bonds in industries that are not highly leveragesd and that have a proven track record of paying back principal and interest.