- DC sponsors have an opportunity to significantly improve their plans by broadening the fixed-income options to include strategies that offer higher income, more diversification, and protection from rising rates.
- Higher income strategies have many investment merits in their own right. Recent modifications to the tax code, though, make tax deferred accounts a most welcome harbor for these investments.
- While plans are diversified among asset classes, the diversification within asset classes is generally only extended to equities. The typical core bond option, with its tilt toward high-quality government-related sectors, severely constrains the risk/return profile available in fixed-income.
- DC investors anticipating a rising rate environment typically have limited investment options. Fixed-income investments such as adjustable rate, higher income, globally diversified, or unconstrained strategies are likely to perform more favorably than the typical core bond option in such an environment.
The traditional fixed-income line-up offered by defined contribution (DC) plans may leave participants wanting given today’s low-yielding, financially repressed market environment. Investors in other channels, both institutional and retail, are seeking strategies that provide: 1) higher income 2) better diversification and 3) protection from rising rates. Shouldn’t these options be available to DC investors?
DC plans were created under the Revenue Act of 1978, which included a provision that eventually became Internal Revenue Code (IRC) 401(k). The law went into effect on January 1, 1980, with larger firms the initial adopters in the early to mid-1980s. Widespread adoption then accelerated throughout the rest of the decade and into the 1990s. Plan design therefore matured during the “Great Moderation,” a period characterized by disinflation and diminishing volatility. Over this period strong equity performance was buttressed by solid fixed-income gains. Even risk-averse investors were at least able to maintain the purchasing power of their savings with stable value crediting rates and money market yields outpacing inflation.
Present day investors face a very different market landscape. In the aftermath of the financial crisis, unconventional monetary policy was implemented to spur healing and quell flares of systemic risk. The artificially low Treasury yields resulting from this policy have investors uneasy about the potential consequences, both intended and unintended. Over the years DC plan design has evolved in many other areas, but the mindset with respect to fixed-income ossified years ago. Most DC plans still offer an insufficient set of tools to navigate the challenges and opportunities ahead, as the menu is typically limited to a stable value and/or a core bond option. Those tools served well in the past given the view that the role for fixed-income was reserved as either a store of value (stable value) or an anchor to windward (core bond). Times have changed, though, as the extraordinarily low nominal yield (negative real yield) environment we all face means the tide is out and the winds have shifted.
The institutional side of the retirement industry (i.e., defined benefit pensions) has been proactively engaged in repositioning its fixed-income investments for years. We’ve heard one industry consultant describe it as the “donut” approach: “everything but the core.” On one side of the institutional curtain, certain private pension plans were forced to adopt a liability driven investing (LDI) approach due to a shift in the accounting and regulatory environment. This approach relies largely on long-duration fixed-income to hedge the liabilities. On the other side of the institutional curtain, many plans remain focused on total returns. Public plans, along with those private plans that can underwrite funded status volatility, have been actively adjusting their fixed-income investments with the common themes of seeking to increase income, improve diversification, and guard against a rising rate scenario.
Where’s the Income?
Investors today are examining their fixed-income investments, seeing quite a bit of duration and wondering where the income is.
It is almost universally recognized now that the current low-yield, financially repressed environment has altered the risk landscape in fixed-income. Unless an investor feels the need for an investment that will profit only in the narrow scenario where systemic risk erupts again and drives rates even lower, near zero policy rates and negative real yields diminish the attractiveness of traditional fixed-income securities such as high-quality government bonds.
At the beginning of the 1990s, the 10-year Treasury bond offered about 8.5% in yield with a duration of approximately 6.5 years. Today, a 10-year Treasury offers only about 2.0% in yield and is tethered to approximately 9 years of duration. Nowadays the price decline from a mere 23 basis-point rise in yields would completely offset the income from this bond for the next year. Investors who once believed that Treasuries offered “risk-free yield” may now characterize these instruments as exhibiting “yield-free risk.”
Yields on US government securities are at or near historic lows, and other investment-grade alternatives, notably corporates and agency MBS, are in similar historic territory. The yield on the Barclays U.S. Aggregate Bond Index has declined to 1.84% as of February 28, 2013, while the Index carries a duration of 5.22 years. The Aggregate Index still serves as the industry proxy for a basket of high-quality bonds, but many investors are balking at that risk/reward profile and are instead exploring opportunities in higher income securities.
The Risk of Being Under-Risked
“Extended” fixed-income sectors such as high-yield, bank loans, emerging markets (EM) debt, and non-agency MBS have traditionally been considered higher-risk investments due to the more significant presence of default risk. “Low-risk” bonds such as domestic government-related securities are assumed to be devoid of default risk, but they are also devoid of much yield today. As highlighted earlier, high credit quality securities are generally attached to higher durations (ceteris paribus) and these days, the dark clouds looming on the horizon for fixed-income assets have many investors more concerned about the threat of a rising rate environment and, less so, an increase in credit default risk.
In a February 2012 white paper, "The Importance of Income" we highlighted the standalone investment merits of higher income assets. While these strategies have generated strong returns since then, the rationale for these investments remains. The underlying fundamentals for these “extended” sectors are generally solid and in many cases have continued to improve. Corporations today are increasingly global, showing year-over-year (YoY) revenue growth, and still managing their businesses and balance sheets defensively as they adjust to this period of economic uncertainty. It has been well documented that EM issuers should continue to benefit from the tailwind of favorable demographics, while many so far have also demonstrated better fiscal discipline than their developed market counterparts. Non-agency MBS has been attractive in the aftermath of the crisis because of the onerous assumptions used to forecast their cash flows even as housing fundamentals are now improving. These higher income sectors also generally exhibit less interest-rate duration, either explicitly or empirically, than higher-quality bonds.
Much of the investing public, both institutional and retail, has already detected the shifting risk landscape for fixed-income as unconventional monetary policy has drained much of the yield out of high-quality securities while leaving these instruments with high duration. Given the current market backdrop, concern over credit risk has waned relative to increasing unease over interest-rate risk. With underlying fundamentals for spread sectors generally solid, perhaps the risk today with artificially depressed yields is being under-risked in the traditional sense.
Complementary Return Components
Each investor has to understand his or her own individual objectives for holding bonds. In a previous white paper, we argued that higher income strategies can also be an alternative to equities as the powerful forces of compounding interest and dollar cost averaging can offer an attractive total return stream with lower volatility. For investors who are looking to complement their equity allocation with other higher return-offering assets, high-income strategies should be considered.
Even if the investors don’t view high-income strategies as equity substitutes, they should be aware of how returns are generated in the conventional asset classes. The traditional framework to portfolio diversification and risk management emanates from modern portfolio theory and involves optimizing allocations to the available asset classes (e.g., stocks, bonds, and cash). Asset allocation decisions today are still based off this concept as witnessed by the target date fund glide paths. Those optimizations continue to be based on assumptions about total returns and the volatility of those total returns. Those assumptions for total returns may not hold true going forward.
When we examine the components of total return, what we see is not surprising in that bonds generate the majority of their return from income, while equity returns are dependent on price appreciation. These two asset classes by and large exhibit complementary return components. The forecast for equity appreciation is always a hotly debated topic that we will not explore here. What is clear is that the foundation for income has been eroded. With the yield of the Aggregate Index at 1.84%, higher income options may be an appropriate substitute.
The Timing of Taxes
Benjamin Franklin once said, “Nothing in life is certain but death and taxes.” Some taxes, however, can be deferred. Congress has long used the tax code to influence behavior in an attempt to achieve certain economic or social objectives. Notable examples include deductions for mortgage interest and charitable contributions. Because the US tax code has established differential treatment of interest income versus capital gains, investors may want to take this into consideration when deciding where certain assets are housed.
As part of the recent January 1 fiscal cliff negotiations, the top federal tax rate for capital gains rose to 20.0%. Interest income is taxed as ordinary income, with the top marginal tax rate now set at 39.6%. Also effective January 1, 2013, high-income earners face an additional Medicare tax of 3.8% on passive income, bumping the top federal marginal tax rate for interest income to 43.4%. State taxes, if applicable, could further stretch the disparity in treatment between capital gains and interest income. Depending on the investor’s tax bracket, passive income could potentially be severely disadvantaged when held in a taxable account.
Each individual investor faces a different set of circumstances. The current tax code should motivate investors to carefully consider where various assets are housed. Certain taxpayers may find it beneficial to shelter income producing assets in tax-deferred accounts to maximize the benefit of compounding interest. Unchained from the burden of tax claims, these assets would then grow until which time they are withdrawn in retirement, presumably when the taxpayer is in a lower tax bracket. Relative to income-producing assets, an investor may find it advantageous to hold their equity investments, which generate the majority of their return from price appreciation in a taxable account given the favorable capital gains and dividend tax treatment. For individuals seeking to build wealth over time, high-income producing assets may be particularly attractive, especially in a tax-deferred account such as a DC plan.
Are You Really Diversified?
As a general rule, the Employee Retirement Income Security Act places an affirmative duty on plan fiduciaries to diversify plan investments. Looking back through the financial culture and media environment under which plan design matured, these efforts focused on diversifying among asset classes. Any diversification within an asset class has usually been reserved for the equity section of the menu. William Sharpe put forward the idea of style analysis in 1988, noting that diverse types of equity investing can be represented in a “style box.” Building on Sharpe’s ideas, firms such as Morningstar display types of equity and fixed income investing in graphs like those in Exhibit 5. Today plans offer equity choices that mostly cover the nine boxes for domestic equities spanning the market cap and value-to-growth spectrum. In addition to these domestic options, most plans have also embraced providing global and EM offerings.
DC fixed-income offerings are typically limited to a stable value and/or a core bond option. Both strategies have strong ties to the Aggregate Index. This Index is lauded for having broad exposure to sectors such as Treasuries, agency MBS and investment-grade corporates. On the other hand, critics lament that this Index is tilted too heavily in favor of government-related, high-quality and domestic issues. Many other opportunities in fixed-income—specifically floating-rate, below-investment-grade and non-USD-denominated securities—are omitted. This suggests that this benchmark, despite being labeled an “aggregate” index, is not particularly well diversified. It may not be necessary to have bond offerings populating every fixed-income style box, but shouldn’t DC participants be offered exposure to bonds targeting exposure to different duration, credit quality, and geographic sensitivities?
DC sponsors that wish to improve the diversification of their plan’s offerings should consider adding: 1) an active core strategy where only a passive one currently exists and 2) fixed-income strategies that offer exposure to sectors, either individually or collectively assembled, separate from the domestic government-related securities so concentrated in the aggregate.
Understanding the risk and return profile of a core bond allocation is critical for plan participants to meet their investment objectives while minimizing unintended consequences. This is especially true of a passive core bond allocation, which further limits an investor’s opportunity set. In a 2011 white paper, "A New Year’s Investing Resolution: Get Active", we argued for the benefits of active management and would reiterate today the urgency of “getting active.”
The affection for passive equity investing is understandable. The argument that low fees lead to better returns is widely accepted. Compared with active equity products, active fixed-income funds charge a fraction of those management fees. After fees, the argument for indexing turns to performance. The notion that the large cap stock market is an efficient market is essentially evidenced by the dearth of active large cap equity managers that have consistently outperformed their indices over long periods of time. We would argue that the fixed-income market is not an efficient market. The over-reliance on ratings, the complexity of many securities, regulatory constraints, and technical supply/demand imbalances all lead to opportunities for active fixed-income managers. A passive core bond product would lock the investor into the components of the Aggregate Index. An actively managed strategy allows the manager to diversify away from the Index. The empirical evidence illustrates that active fixed-income products have generated considerable value added for investors over a long period of time.
Protection From Rising Rates
Even active strategies only have so much leeway to drift from their benchmark indices, especially on the duration management front. Rate volatility has been muted lately, given the extraordinary central bank intervention in the markets. This was not the case prior to the crisis. Standard guidelines for US core type mandates find their origins in the 1970s (arguably the start of the active bond management industry), and duration limits were typically kept tight given the volatility of rates at that time. Industry standards expect portfolio durations to range within 20.0% of that of the benchmark index. For a core strategy, that means active managers have about 1 year of leeway around the aggregate’s duration of 5.
For investors wary of a rising-rate environment, even the flexibility of an actively managed core bond strategy doesn’t provide enough comfort. The popularity of floating-rate and unconstrained strategies in other channels, both institutional and retail, is evidence of the desire to protect capital from the potential impact of rising rates. Higher-yielding strategies have also performed reasonably well in periods of rising rates. Spread compression, in reaction to improved economic conditions, and the higher income itself, compensated to various degrees the negative effects of rising rates. These strategies are typically not available to defined contribution participants.
Both plan sponsors and investors should recognize that the artificially repressed low-yield environment has transformed the risk landscape for bonds. What is needed is a deeper understanding of the role that the fixed-income allocation is intended to play in one’s portfolio. While the regulations do not place an affirmative fiduciary duty on plan sponsors to educate their employees about the ever-shifting financial markets, many plan sponsors have wisely offered some direction despite the steep learning curve. Sponsors can also have an immediate positive influence on their plans by reevaluating their multi-asset offerings such as custom target-date or balanced strategies, often the Qualified Default Investment Alternative, or QDIA, in their plan.
Plan sponsors should consider whether their traditional DC line up of a stable value and core bond option will be sufficient to navigate the path ahead. Fixed-income investors in other channels are looking for income, diversification and protection from rising rates. A number of strategies already exist that seek globally diversified sources of high-income are floating-rate in nature, or unconstrained, and have served other clients quite well. Shouldn’t DC plans in which interest income receives favorable tax treatment offer these same opportunities to their participants?