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Retirement Perspectives

Although not all bonds are alike, they offer diversification and a different risk profile to equities, making them a critical component of the defined-contribution investment lineup. 

 

In Brief

  • Bonds are considered a critical component of any carefully constructed plan menu requiring plan sponsors to prudently consider the number and variability of fixed-income options to offer.

  • Bonds historically have added benefits to a portfolio, including low volatility and negative correlation with the S&P 500® Index.

  • Not all bonds are created equal, and different sectors of the bond market may behave differently, depending on the economic environment (recessionary, growth, inflationary, etc.).

  • In the interest of portfolio diversification and given the risk profile of many participants, plan sponsors might do well to consider four bond categories within their plan’s fixed-income lineup:
    - Total return
    - Short duration
    - ‘BBB’ rate corporate debt
    - High-yield/emerging-market debt

  • The key takeaway—Bonds can play an important role in the retirement-planning process and can warrant a place in every defined contribution lineup. The “Core” bond option should offer participants safety, attractive risk-reward characteristics, and a low correlation to equities. Additional fixed-income choices should satisfy a participant’s desire for either lower volatility or greater return. A short-duration alternative offers the potential for less volatility, while corporate bonds, high-yield bonds, and emerging-market bonds could offer higher potential return with additional risk.

 

The task of selecting a fixed-income lineup is a crucial part of the overall design of a defined contribution (DC) investment menu. Aging plan participants, record-low interest rates, a more conservative post–financial crisis approach to investments, and fiduciary responsibility are some of the more pressing reasons to consider the number and types of fixed-income alternatives offered within a plan.

Historically, DC plans also have been viewed as savings plans,1 potentially minimizing the need for fixed-income alternatives. However, as DC plans become retirement plans instead of savings vehicles, robust fixed-income options seem destined to become more important to participants’ retirement-planning process—and the investment menu sponsors provide.

With this in mind, we willl explore in this article the third in our “Building Better Lineups” series: how plan sponsors can build a better lineup of bond funds to best serve the needs of their plan participants. (The other articles in this series explore crafting an effective overall investment menu and selecting an optimal array of equity investment options for a DC plan.)

Why Own Bonds?
Fixed-income investments play an important role in an investment lineup by offering plan participants much needed diversification to equities. As shown in Chart 1, bonds (as represented by the Barclay’s U.S. Aggregate Bond Index) historically have held up well when other assets have faltered. In fact, since the inception of the Barclays Aggregate in 1976, stocks (as represented by the S&P 500® Index) have experienced seven years of negative returns represented in Chart 1. In each of those down years for stocks, intermediate-term high-quality bonds, as represented by the Barclay’s U.S. Aggregate Bond Index, has provided positive performance, posting an average annual return of 8%.

It also is worth mentioning that the Barclays Aggregate has had only three years of negative returns since its inception, and all the while it has displayed low volatility, with an average standard deviation of 5.48% since inception (as of September 30, 2014), compared to 15.36% for the S&P 500 for the same time period, based on data from Morningstar. (In more recent times, the Barclays Aggregate has displayed even lower volatility, with an average standard deviation of 3.24% over the 10 years [through September 30, 2014], while figure for the S&P 500 is still around 14.71% for the same time period.) 

 

Chart 1. Bonds Historically Have Posted Positive Returns in Years When Stocks Have Fallen
Returns for the Barclays U.S. Aggregate Bond Index and the S&P 500 Index 

Source: Barclays and Bloomberg.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Returns during other time periods may vary. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Stocks are subject to greater risk and market volatility, while bonds are subject to greater risk of default and interest rate volatility.

 

The Bond Market—Not All Bonds Are Alike
Instead of asking “Should I include bonds in my lineup?” we would suggest that a better question would be: “Which bonds should you make available within your plan?”

It is not uncommon to hear investors describe bonds as an all-or-nothing proposition. But the bond market is large and very diverse, and not all bonds act alike. Most people also do not realize that the total bond market is nearly two times the size of the stock market. There are many different types of bonds, ranging from U.S. Treasury bonds (typically considered the safest and highest quality) all the way down to junk-rated corporate bonds.  In addition, these bonds can act very differently in different economic environments, and performance can vary dramatically between bond sectors from one year to the next (see Table 1).

In general, there are “two faces” to the bond market: 1) interest rate-sensitive bonds and 2) credit-sensitive bonds. Not all bonds fall neatly into these two categories, but as illustrated in Chart 2, we can look at the two extremes: U.S. Treasury bonds tend to be very sensitive to the behavior of interest rates, while corporate bonds (especially those of lower quality) tend to be more sensitive to economic activity. Of course, there are many risks and other factors that affect different types of bonds. 

For plan sponsors, acknowledging that such diversity exists within the bond markets is the first step in understanding the role bonds can play in participant’s portfolio, and, therefore, the need to make available an adequate number of bond options within the plan. 

 

Table 1: Diversification in Fixed Income: Bond Market Returns Vary (as of 09/30/2014)

Source: Barclays Live and Credit Suisse. Sector returns shown are Barclays indexes as follows: U.S. Aggregate Index, U.S. MBS Fixed Rate Index, U.S. Corporate Investment Grade Index, Municipal Bond Index, U.S. Corporate High Yield Index, U.S. Treasury Index, U.S. TIPS Index, ABS Index, and U.S. Agency Index. 
Credit Suisse Leveraged Loan Index used for leveraged loans. Past performance is no guarantee of future results. Current performance may be higher or lower than the performance data quoted. This historical table is an illustration of the most commonly used indexes representative of various sectors of the bond market and does not depict or predict the performance of any Lord Abbett mutual fund or any particular investment. Please note not all sectors are represented nor is this an asset allocation recommendation. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Chart 2: The Bond Market Is Large and Diverse

Source: SIFMA; Q2 2014 data, updated as of 09/18/2014. Excludes money markets and municipals.
Source: Russell 3000; data as of  September 30, 2014.
Please note: Stocks are subject to greater risk and market volatility, while bonds are subject to greater risks of default and interest-rate volatility.
Data are most recent available.

 

Fixed-Income Menu Construction—Key Considerations
Consider the message received by plan participants whose menu offers five equity alternatives and one fixed-income option. Based on the orientation of that solitary fixed-income option, a decision by some participants to equal weight such an investment array likely will produce a portfolio that may be much riskier than the “neutral” portfolio the participant may have been intending. The number and variability of fixed-income options can, therefore, be an important plan sponsor decision. If additional fixed-income options improve portfolio diversification and investment success, they also may help sponsors fulfill their fiduciary responsibility. 

Additional fixed-income options also may be warranted given the risk profile of participants. While risk profile can be a function of age, gender, or corporate culture, it also can be related to financial events or business cycles. The 2008–09 financial crisis may have increased investor sensitivity to equity volatility.  Participants may be seeking a greater number of fixed-income options than they would have considered prior to the financial crisis. In a similar vein, historically low interest rates also suggest additional fixed-income options may be timely as well as appropriate. 

A more plan-specific influence on fixed-income menu selection will be plan demographics. Older participants likely will seek to emphasize safety as their primary investment goal, increasing the need for more than one or two fixed-income options. Consider too that older participants who may desire more age-appropriate fixed-income investments tend to have larger account balances from years of accumulating retirement savings, and, collectively, these older participants may account for the largest portion of plan assets. 

Thus, there are a variety of reasons to expand fixed-income menu options, often driven by factors that shift investor priorities to stability, portfolio diversification, and an offset to equity volatility. In the next few sections, we’ll review specific bond options that plans may consider to possibly address all of the above factors.

1) Building a Solid Foundation—Total Return (Core Plus)
Constructing a bond lineup begins with selecting a core bond fund that will serve as the foundation for most participants’ bond allocations. Given the important role of this Fund, it is worth clarifying that the term “Core Bond” can have a double meaning.

As we initially used the term, a “core” bond fund can refer to the fund that the plan ultimately chooses to serve as the foundation for the bond lineup. But a core bond fund also can refer to the Core Bond asset class (traditionally represented by the Barclay’s U.S. Aggregate Bond Index). As illustrated in Chart 3, these “core” bonds—that is, those of higher credit quality and intermediate maturities—historically have added benefits to a portfolio, including low volatility and negative correlation with the S&P 500® Index. [Of course, there is no guarantee that these asset classes will perform similarly in the future.]

For yield and potential return greater than the traditional Core Bond option, some consultants suggest a Core Plus, or Total Return, option as an appropriate solution for participants. Compared to a Core Bond option that resembles the higher-quality Barclays Aggregate Index, a Total Return option generally holds a larger allocation to non-U.S. government securities—including some lower quality securities—and often a modest allocation to emerging market debt. 

While such a shift in composition sounds like a Total Return option would offer a meaningful alternative to a Core Bond option, in fact, the risk-reward profiles of the two options are not substantially different.  Chart 3 shows the 20-year risk/reward profile of both options.  Using 10- or 15-year time frames produces similar results.  

 

Chart 3. The First Component: Total Return versus Core
Standard deviation and total return of indicated strategies (10/01/1984-09/30/2014)

Source: Morningstar. Total return strategy is represented by the Barclays U.S. Universal Bond Index. Core bond strategy is represented by the Barclays U.S. Aggregate Bond Index.
The Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index, and the non-ERISA portion of the CMBS Index. Municipal debt, private placements, and non-dollar-denominated issues are excluded from the Universal Index. The only constituent of the index that includes floating-rate debt is the Emerging Markets Index.
The Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.
Standard deviation is a measure of a measure of volatility. It indicates the variability of an investment's returns.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Returns during other times may vary. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction or expenses, and are not available for direct investment.
Past performance is no guarantee of future results.  The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall.

 

One explanation for the similarity of volatility is that the concentration of government securities lends interest-rate sensitivity to the Core Bond option, while the higher-yielding corporate, high-yield, and emerging-market debt offer diversification effects of credit sensitivity to the Total Return option.

Given the risk/return similarity between the two options, the Total Return option is not effective as an additional alternative, but it can be an effective substitute for the Core Bond option. Therefore, based on historical relationships, a plan would not offer a meaningful choice to participants if it included both Core Bond and Total Return options. A plan might, however, offer Total Return instead of Core Bond, if we assume that the risk-reward characteristics of both funds resemble historical experience. Whether opting for Core or Total Return, the plan sponsor should choose an experienced manager able to demonstrate value added through a reliable process. Confidence in the management of this option is important, as this selection is likely to form the fixed income foundation for most participants.

With that said, while the traditional one-size-fits-all “core” bond fund may do an acceptable job of addressing some participants’ need for safety and low correlation to equity returns, the “core” bond may be inadequate for participants who seek less volatility, higher return, or broader fixed-income diversification.

2) Reducing Volatility—Short Duration
Whether the foundational choice is a Core Bond option or a Total Return option, additional fixed-income choices should initially satisfy two investor goals: reduced volatility and greater return potential. Assuming the plan begins with a Total Return option, a short-duration alternative could be most effective at providing a less volatile fixed-income choice. Short Duration can include a variety of asset classes, but its defining feature—the restriction of the maturity of portfolio securities—makes it a choice that is meaningfully different than Total Return. A one- to five-year option or more intermediate-maturity class tends to place the volatility close to that of the Total Return option. Instead, a one- to three-year benchmark provides meaningful differentiation from the Total Return option. A one- to three-year corporate bond index is plotted in Chart 4, illustrating a markedly less volatile alternative to the Total Return option.

Plan sponsors can investigate a number of one- to three-year fixed-income options for this alternative, but a broadly diversified portfolio seems consistent with the objectives of an investor choosing this option. One final note: plan sponsors also should verify whether or not a short-duration fund would be deemed a “competing fund” with an already available stable value investment within the plan lineup, therefore precluding the investments availability. (Additional information on this concept may be explored on the DOL’s main website, http://www.dol.gov/ebsa/publications/2009ACreport3.html.)

 

Chart 4. The Second Component: Short Duration
Standard deviation and total return of indicated strategies (10/01/1984-09/30/2014)



Source: Morningstar. Total return strategy represented by Barclays U.S. Universal Bond Index. Short duration strategy represented by BoA Merrill Lynch 1-3yr Corporate Index.
The Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index, and the non-ERISA portion of the CMBS Index. Municipal debt, private placements, and non-dollar-denominated issues are excluded from the Universal Index. The only constituent of the index that includes floating-rate debt is the Emerging Markets Index.
The BofA Merrill Lynch 1-3 year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.
Standard deviation is a measure of a measure of volatility. It indicates the variability of an investment's returns.

 

Plan sponsors can investigate a number of 1-3 year fixed income options for this alternative but a broadly diversified portfolio seems consistent with the objectives of an investor choosing this option.

3) Enhancing Return—Corporate Bonds
Having balanced a Total Return option with a less volatile Short Duration option, a third fixed-income choice is needed to address the investor goal of greater potential return. 

Greater return generally can be captured with greater interest rate risk (longer maturity) or with greater credit risk. Given the potential for yield-curve inversions, when longer maturities yield less than shorter maturities, and with even the experts unable to consistently forecast interest rates with any degree of success, it would seem advisable to place greater emphasis on credit risk rather than interest rate risk.  Credit risk can be managed by limiting the exposure to certain rating categories, by identifying a manager capable of analyzing the safety and valuation of corporate credits, or both. Chart 5 plots a Corporate Bond option that focuses on 'BBB' rated issues. 

 

Chart 5. The Third Component: Corporate Bonds
Standard deviation and total return of indicated strategies (10/01/1984-09/30/2014)


Source: Morningstar. Total return strategy is represented by the Barclays U.S. Universal Bond Index. Short duration strategy is represented by the BoA Merrill Lynch U.S. Corporate 1-3 Yr. Index. Corporate investment-grade strategy is represented by the Barclays Corporates Baa Index.
The Barclays U.S. Universal Index represents the union of the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index, and the non-ERISA portion of the CMBS Index. Municipal debt, private placements, and non-dollar-denominated issues are excluded from the Universal Index. The only constituent of the index that includes floating-rate debt is the Emerging Markets Index.
The BofA Merrill Lynch 1-3 year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.
The Barclays Corporates Baa Index is the Baa component of the U.S. Corporate Investment Grade Index. The index includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.
Standard deviation is a measure of a measure of volatility. It indicates the variability of an investment's returns.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Returns during other times may vary. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction or expenses, and are not available for direct investment.
Past performance is no guarantee of future results.  The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. 

 

Compared to the Total Return and Short Duration option, the ‘BBB’ Corporate option provides participants an opportunity for additional return and a meaningfully different choice. Depending on the culture of the firm and plan demographics, sponsors may choose to tilt to higher or lower quality and still succeed in offering an alternative that provides higher potential return than the Total Return or Short Duration options. 

The three alternative fixed-income structures of Short Duration, Total Return, and Corporate Bonds is an effective plan structure that provides a traditional fixed-income option with clear opportunities for participants to adjust for lower volatility or higher return potential. Especially when combined with a money market alternative, such an array provides the necessary basic components to meet different investor needs and some flexibility to address changing objectives as retirement nears.

4) Additional Options—High-Yield and Emerging-Market Bonds
Beyond this simple structure, additional fixed-income choices may be appropriate to for investors seeking the potential for even higher return. Investors who have been dissatisfied with the equity market or who don’t mind volatility but need higher income may be interested in other fixed-income options, such as high-yield or emerging-market debt. These alternatives may in some cases substitute for some equity exposure in other cases or supplement the fixed-income allocation with additional potential income.  Chart 6 provides a risk/reward representation of these alternatives relative to the three other options previously discussed. 

 

Chart 6. The Final Components: High-Yield and Emerging-Market Debt
Standard deviation and total return of indicated strategies (10/01/1984-09/30/2014)


Source: Morningstar. Total return strategy is represented by the Barclays U.S. Universal Bond Index. Short duration strategy is represented by the BofA Merrill Lynch 1-3 year U.S. Corporate Index. Corporate investment-grade strategy is represented by the Barclays Corporates Baa Index. High-yield strategy is represented by the Credit Suisse High Yield Index. Emerging-market bonds strategy is represented by the J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified (CEMBI BD).
When constructing a retirement plan lineup, plan sponsors should have a sense of the risk (as measured by standard deviation) and return characteristics of different assets classes. This can help inform their decision to eventually select specific investment to make available to participants. As represented in the chart below, we can see that each strategy offers a different risk/reward profile and therefore may warrant a spot in a diversified investment menu. 
Standard deviation is a measure of a measure of volatility. It indicates the variability of an investment's returns.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Returns during other times may vary. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction or expenses, and are not available for direct investment.
Past performance is no guarantee of future results. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. 

 

Again, both the High Yield and Emerging Market option provide risk/reward profiles that are different than other options presented. 

Other fixed-income options can be included to address specific investor needs or to take advantage of specific opportunities. For those concerned about inflation, inflation-protected securities may be an effective option. Bank loans may appeal to investors especially during periods of economic strength and tightening monetary policy. However, care must be exercised to avoid the truly esoteric or faddish options such as specific emerging-market country debt or portfolios designed for short-term market “bets.” Such options are likely to soon be “zombie” funds with only residual assets once the investment fad fades.

Conclusion
The scope of the fixed-income markets allows a variety of menu options that provide different volatility and return characteristics. When selecting investment options for a DC plan, sponsors should weigh plan demographics, diversification considerations, and fiduciary responsibility. Decisions to add options should be based upon their ability to meet investor goals while offering a distinctly different risk/reward profile than other options. The resulting structure will enable choice among different asset classes, not selection among similar portfolios. If sponsors’ efforts are successful, participants will be offered a well-balanced investment array from which to choose. And sponsors can be confident that they have responsibly designed a diversified plan that meets the investment needs of participants.

Steve Vendor, “The Next Evolution in Defined Contribution Retirement Plan Design,” Stamford Center on Longevity, September 2013.

 

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