Jake Gilliam, senior multi-asset class portfolio strategist, Charles Schwab & Co., recently spoke with PLANADVISER about some of his chief concerns with recent developments in the fixed-income marketplace.
Particularly when it comes to the fixed-income allocations of target-date funds, Gilliam says he has noticed plan sponsors and participants carry something of a false sense of security. Since the financial crisis of a decade ago, in an effort to combat years of incredibly low interest rates, some active fixed-income strategies held in TDFs have taken on additional risk within their portfolios. “As a result, some TDF fixed-income exposures risk the potential of behaving more like equities than bonds, should significant market stress return,” Gilliam suggests.
“And the timing couldn’t be worse for many retirement investors,” he feels, “An elevation in fixed-income risk can jeopardize accumulations when participants, especially the Baby Boomers, are at their most vulnerable, as they near retirement.”
As an illustration, Gilliam discusses what it takes today versus a decade ago to secure a 5% yield through fixed-income investments. In 2007, it could be done while taking virtually no credit risk using more or less only U.S. Treasury securities. A mere two years later, investors needed to utilize U.S. corporate investment-grade bonds to achieve that same coupon level, Gilliam notes, and today in August 2017 a similar 5% coupon requires “venturing into Ba-rated U.S. high-yield bonds, representing a significant elevation in credit risk relative to U.S. Treasurys.”
The real concern is that greater exposure to higher-yielding corporate bonds can “notably dampen a fixed-income allocation’s diversification benefits to equity investments.” Crucial for plan advisers and sponsor clients to note, Gilliam says this stretching for yield is very common in the TDFs that are most popular in the U.S. defined contribution plan market.
“Consider the historically negative return correlation of the Bloomberg Barclays Capital U.S. Aggregate Bond Index to the Standard & Poor’s (S&P) 500 Index,” Gilliam continues, “which has allowed the bond index to perform as an effective cushion against stock market downturns. Investment-grade and high-yield corporate credits have failed to offer the same degree of protective attributes, instead moving more in tandem with stocks. This greater correlation to what is often the riskiest part of participants’ retirement savings may subject them to greater downside exposure just when they need the most protection—when equity markets turn volatile.”
Gilliam urges advisers and their clients to weigh these questions in an effort to reassess fixed-income risk: “What is the strategy’s yield, and how is it being generated? What is the strategy’s credit exposure across securities, and how does this differ from the benchmark? How have these attributes changed across different bond market cycles? What is the potential risk to participants, particularly those nearing or in retirement?”
“Plan sponsors and advisers may also find it useful to review if and how a fixed-income strategy’s risk exposure may evolve at various points along the glide path,” he concludes.