Asked how her team is responding to the prolonged low interest rate environment—which many commentators call the new normal—Anne Lester at J.P. Morgan Asset Management says this is not an easy question to answer.
Lester’s dual role of portfolio manager and head of retirement solutions for J.P. Morgan has her focused both on the nitty gritty of target-date fund (TDF) management and on the asset management firm’s higher-level strategic objectives. She says no environment feels easy when it comes to managing a suite of TDF portfolios, but there are some unique challenges emerging for retirement plan investors with respect to the prolonged low rate environment.
“It’s a big question, and it’s hard to answer directly,” Lester says. “What are you going to do with your fixed-income exposure now that rates have remained so low and appear poised to remain so? I think it’s a topic that everyone naturally wants to discuss right now, but I tend to reframe this question to relate it back to the bigger picture.”
The Tactical Outlook
According to Lester, what a market observer can say with confidence is that interest rates have remained at historic lows in the developed world. There is little sign that rates will climb quickly, 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 asks. “Where do you put your money to work in an environment where it does not appear to us that there is anything that is ‘cheap,’ and where we have to think about a multi-decade time horizon for our clients? What is the role of fixed income in the portfolio in this context?”
Echoing the language of her peer managers, Lester says that, at the beginning of the glide path in particular, fixed income’s real role is as a diversifier, not a return generator. As an investor moves down the glide path and nears retirement, fixed income becomes both a more significant relative return generator and a portfolio diversifier—as well as a stabilizer of returns. It’s important to remember, as well, that an investor at their retirement date may need their nest egg to last several decades, Lester says, meaning they can’t take risk entirely off the table.
“Obviously, the more fixed income you have, the more stable your return stream will become as a general matter,” Lester says. “Remember, as we think about where interest rates will go from here, a really bad year in the fixed-income markets would be a negative return in the single digits. That would be a catastrophically and historically bad return—so putting what might happen in the fixed-income market into context, vis a vis the equity markets, is important. When people hear ‘bear market,’ they think of the equity markets pulling back in the double digits, perhaps 20% or 30% pullbacks. In fixed income, the parallel catastrophic scenario is much less extreme.”
However, as Lester notes, what makes losses on the fixed-income side of the portfolio really painful is that it was supposed to be the “safe” part.
“Looking forward, our current strategic orientation to fixed income is, essentially, to not have as a glide path holding non-U.S. fixed income, aside from emerging markets, because we don’t think that sector has an attractive risk-return profile.” Lester 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.”
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 [the Bloomberg Barclays U.S. Aggregate Bond Index], but in our view, it is very important not to just blindly own the Agg in passive ways,” Lester adds. “We argue investors need active managers who are able to pull on all the levers—security selection and duration decisions—especially in an environment like this.”
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,” Lester 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 as this ‘new world’ continues to unfold. “
Some Strategic Perspective
Like Lester, Scott Donaldson, a senior investment analyst in the Vanguard Investment Strategy Group, spends a lot of time analyzing both TDF management decisions as well as the broader progress of the market. Working at Vanguard, which is known for its passive, index-based approach to retirement investing, it’s no surprise that Donaldson has a somewhat different take on the best way to navigate this fixed-income environment.
“First and foremost, from a fiduciary standpoint, all of this is important to think and talk about,” Donaldson says. “Most of the money in target-date funds has gotten there through the default option in defined contribution retirement plans. Plan sponsors have been responsible for choosing these funds as defaults, and certainly the interest rate environment that we have experienced, the historic and prolonged low levels, is a cause for consideration and review.”
Donaldson says that, generally speaking, 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 will inevitably face at different points in their savings journey.
“For most people owning target-date funds, even those at or near the retirement date, they have a long-term horizon of potentially several decades. Over that time period, they will face various challenges, inevitably, whether that is an equity market downturn or interest rates rising or falling quickly, or any other type of global geopolitical event that can put markets into disarray,” Donaldson explains. “Our view is that the glide path really needs to be enduring, through all those types of markets, to best serve the long-term goals.”
Strategically, 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 diversification 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,” Donaldson says. “This means that, if something goes significantly wrong, that extra 50 basis points you tried to squeeze out of the market may pale in comparison to the downside you could experience if the equity market was to go significantly wrong.”
In terms of specific holdings, Donaldson says, Vanguard invests sizably and believes strongly in the diversification potential of high quality non-U.S. government bonds. 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, 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 they are, in some cases, negative,” he says. “Our strategy involves hedging the currency exposure to lower the volatility of those fixed-income instruments. In this sense, we’re not really giving up yield, we argue; we’re just getting it differently in an equivalent total return.”
The Equity Equation Also Matters
Another expert in this space is Toni Brown, senior defined contribution specialist at Capital Group, home of American Funds. Brown says her firm, too, is grappling with the complex and interrelated questions of how to assess the interest rate environment and how to treat the fixed-income side of the TDF glide path. She also emphasizes the importance of linking in the equity side of the equation.
“Generally speaking, we have higher equity representation throughout our glide path relative to other providers,” Brown observes. “The reason we do this is because people retiring at 65 have a life span projection that can range up to 95 or older. We cannot just take risk off the table for this group, but at the same time we do have to be more conservative and defensive on the equity side of the portfolio as well.”
For Capital Group’s American Funds TDFs, what this means is that the glide path’s equity component moves over time away from the broad-based equity that is a core component early on in the investor lifecycle. In turn, the equity holdings move into more conservative, dividend-paying and dividend-growing strategies, Brown explains.
When it comes to the interest rate outlook, Brown agrees that the key message is “lower for longer.” The firm also has lower expectations for what equity markets will do in the coming years relative to the long bull market investors have enjoyed.
“You have to really focus on the risk of the total portfolio as well as the fixed-income component to effectively serve older participants,” Brown says. “At this time in the business cycle, we think it is important to have the portfolio constructed to do well in any type of market environment. We don’t think now is the right time to reach for yield, because that will entail taking on more risk. Instead, we are very long-term oriented, and we understand there will be cycles, and you don’t know where you are in any particular cycle, so you have to have an all-weather portfolio.”
With these factors in mind, Brown says, American Funds’ TDFs are “built to keep up in rising markets and then do really well in declining markets.”
“This performance in declining markets is so important, in our view,” Brown says. “When retirees are taking money out, this is an entirely different consideration versus what happens when younger investors experience losses and can ride out the recovery. These older people drawing income essentially lock in their losses. Mitigating sequence of returns risk is critical, as is establishing and sticking to your long-term strategy.”