“Unconstrained Bond Investing: Examining the Case for Absolute Return Strategies for DC Participants” looks at how switching a portion of conventional bonds into some form of absolute return strategy may improve DC plan outcomes. The paper cautions, however, that investors need to be mindful of the risks introduced and ensure sufficient focus is placed on retaining a robust strategic asset allocation and achieving value for money.
“The paper challenges the conventional mindset around how defined contribution plans gain bond exposure,” Lorie Latham, senior investment consultant for Towers Watson, tells PLANADVISER. “Through review of the changing fixed income landscape and investment opportunity set, the paper explores how adjusting bond exposures away from core mandates can add value.”
With interest rates at or near historic lows across developed worlds, absolute return investing is attracting much attention, says Latham, adding, “There is a great deal of emphasis on evolving defined contribution plans to aim for improved retirement outcomes. DC plans have historically been anchored to a simple Barclay’s Aggregate benchmark, resulting in a U.S. interest rate and geography bias. Our analysis concludes that a more diversified approach can have a meaningful impact over the long-term for DC plans. In a total portfolio context, our analysis reveals that diversifying bond exposure beyond traditional structures has the potential to improve the risk and reward profile and outcomes for participants.”
The paper notes that the idea of interest rates and yields being more likely to increase than decrease has important implications for the sort of bond products that asset managers are launching. Recent years have seen a variety of products launched to exploit or protect against the “seemingly inevitable rise of bond yields.” This includes funds that are variously labeled as absolute return bond funds, unconstrained bond funds and numerous other strategies.
The paper defines absolute return bond funds as funds with a goal of creating an “all-weather” portfolio that is robust across market environments. In addition, such funds should deliver strong returns over the medium term, but will regularly have single years of negative returns. Absolute return bond strategies have low interest rate sensitivity, typically with a neutral duration position close to zero, and may have the scope for small negative duration, benefiting directly from rising yields.
The paper defines unconstrained bonds as those utilizing strategies that seek to generate positive returns in all market environments. These funds typically permit the flexibility to lever up returns, express an absolute negative duration position and generally carry more and lower quality credit risk, including sub-investment grade credit.
While the attention surrounding absolute return bonds has been driven by expectations and concerns over rising interest rates, the paper notes that it is important to retain a more holistic and longer-term perspective when assessing the merit of adding these strategies. The paper further notes that most investors do not have the time and investment insight required to successfully switch between strategies across an economic cycle, pointing out that it is “unrealistic and dangerous to try to optimize portfolios to a specific macro regime that may prove to be relatively short-lived, or indeed take some time to materialize.” Instead, the paper recommends identifying a structure that is a good fit for the current macro regime and across a market cycle.
In terms of how a DC plan sponsor can determine the best route for implementing various absolute return type solutions, Latham explains, “In our analysis, we shifted a portion of a total portfolio to an absolute return strategy, which resulted in improved risk-adjusted returns in a total portfolio context. We do not believe offering an absolute return strategy as a stand-alone option on a DC platform is the right approach. Our view is that DC plans should de-emphasize single style investing and aim for simplification to aid participants in decisionmaking.”
Latham clarifies that strategies such as absolute return should be offered within a diversified structure such as white label funds or as part of a custom target-date fund series. She acknowledges that while this approach is a higher governance proposition, it also allows portfolios to be approached in “a more holistic manner.”
The paper also recommends an assessment framework for different absolute return strategies involves testing their efficacy against key goals of such an allocation. These rules for assessment include:
- Do not increase the correlation to equity. Any investment strategy change must be assessed against the impact on the overall sensitivity to equity markets and overall level of risk.
- Improve returns in a rising interest rate environment. This can mean either structurally different exposures or more dynamic management of exposure.
- Improve robustness of returns in all environments.
- Do not increase correlation to current investments or the dependence on existing managers.
- Find a solution that is appropriate to DC participants. “Appropriate” is defined as being liquid in nature and easily understandable to participants.
The full text of the paper can be downloaded here.