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Retirement Perspectives

Three key questions defined contribution plan sponsors should consider asking about their intermediate-term bond investment option.

Since the enactment of the Pension Protection Act of 2006, a significant transformation of investment menu structure and offerings has occurred in defined contribution plans. Throughout this evolution, however, one tenet of portfolio construction has remained constant: the need to offer participants options for capital preservation for portfolio diversification or to potentially reduce overall portfolio risk. This especially is important for millions of baby boomers approaching retirement. Defined contribution plan sponsors historically have relied on offering an investment option from an Intermediate Term Bond category to help satisfy the need for capital preservation. The intermediate-term bond category is vast in size and contains a broad range of investment styles, allocations, and risk profiles. Contrast this with many equity fund categories that can be more clearly defined by factors, such as market capitalization and styles value and growth. Just how large and varied? Consider the following statistics for the Morningstar Intermediate Term Bond category, as of January 31, 2017:

  • 1,013 funds, totaling $1.16 trillion in assets
  • 302 funds in the category when screening for multiple shares classes of the same fund
  • Average effective duration for funds in the category ranges from 2.3 years to 7.3 years1
  • Corporate bond allocations range from 0% to 95%2
  • Asset-backed security allocations range from 0% to 47.9%3
  • Non-investment-grade bond allocations range from 0% to 66.2%4

Many plan sponsors, along with their consultants, often will use peer-group rankings to sort through managers and to identify appropriate investment options for plan participants. With historically low interest rates persisting in the years following the global financial crisis of 2008–09, even small differences in asset allocation and, ultimately, returns could make huge differences in manager peer ranking and determine whether a particular intermediate bond fund is selected by a plan sponsor. Consider that (as of January 31, 2017) the difference between the twentieth percentile-performing intermediate-term bond fund and the fiftieth percentile was a mere 50 basis points, or 0.5%, on a three-year average annual return. (For investment menu consideration, many plan sponsors will set an initial minimum peer group-ranking hurdle of better than the fiftieth percentile on a three-year and five-year basis.)

While portfolio managers may be well aware of the risks associated with holding certain sectors and securities to obtain incremental returns and, as a result, better peer rankings for an intermediate-term bond fund, the plan sponsors that hire those top-performing managers may not be fully aware of the risks associated with investing in those fixed-income sectors and specific securities. Certain fixed-income sectors and securities may affect how the portfolio fulfills the goal of capital preservation in a difficult market environment and how the portfolio may interact with other fixed-income investment options offered.

Prior to going through a performance evaluation of the current intermediate-term fixed-income option relative to the peer group, plan sponsor investment committees may wish to address the three following questions:

Question #1: What is the purpose of the intermediate-term bond offering inside a defined contribution plan?
Much like the abdominal core muscles of the human body, the intermediate-term bond offering is often used as a stabilizer in a defined contribution portfolio rather than a key contributor to overall capital appreciation. The Bloomberg Barclays U.S. Aggregate Index typically is used as the primary benchmark for intermediate-term bond performance in defined contribution plans.  Bond portfolios with the objective to produce a return profile similar to that of the Bloomberg Barclays Aggregate Index. This index is often is referred to as “core.”  Ideally, “core” portfolios are able to produce returns in excess of the benchmark and fees, while not adding additional risk. Chart 1 depicts the performance of the Bloomberg Barclays U.S. Aggregate Index during the seven years since 1976 in which the S&P 500® Index has produced negative returns. In each of those seven years, the Bloomberg Barclays U.S. Aggregate Index produced positive returns. These historical years of positive returns during time periods of equity declines has made the Bloomberg Barclays Aggregate index a popular choice for capital preservation. 

If a plan sponsor investment committee is in agreement that the intermediate-term bond offering should be a source of stabilization and capital preservation for the overall investment menu, the committee can determine whether the current investment menu option would be able to fulfill that objective based on the investment process, holdings, and manager biases toward certain sectors.

 

Chart 1.  Intermediate-Term Bonds Have Had Positive Returns During Difficult Equity Markets

Source: Morningstar. Past performance is no guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. During other time periods index returns may have had different results. 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.

 

Question #2: What does the current intermediate-term bond option actually invest in?
After reviewing fixed-income sector returns for calendar years since the financial crisis of 2008–09, it becomes clear why fixed-income managers have looked to widen intermediate mandates and include holdings different than the historical composition of the Bloomberg Barclays Aggregate Index. For example, Table 1 illustrates that high yield has been the top-performing sector in five of the last eight calendar years since 2008. In 2016 alone, high yield outperformed Treasury bonds by more than 16%, the widest margin since 2009. The primary allocations to government debt in the Bloomberg Barclays Aggregate Index have faced a series of hurdles to performance, such as the persistence of a low interest-rate environment and the potential for interest-rate increases. Additional mandate flexibility has allowed fixed-income managers to invest in fixed-income sectors that have outperformed. Given this environment, defined contribution plan sponsors may lose sight of the original intent of the intermediate-term investment option and pick managers that have generated higher returns by taking risks in sectors that may not deliver the expected capital preservation when desired. While many top-performing intermediate-term bond funds continue to use the Bloomberg Barclays Aggregate Index as their benchmark, their asset allocation may look significantly different.   

If the Bloomberg Barclays Aggregate Index is the preferred index to evaluate managers, defined contribution plan sponsors may wish to get a deeper understanding of how “core” their current intermediate-term bond option truly is. It is noteworthy, however, that in the 12 years represented in Table 1, the Bloomberg Barclays Aggregate Index was never in the bottom three performing sectors, and had only one year (2013) of negative returns. (During that year, the S&P 500’s total return was 32.39%.)

 

Table 1. High Yield Has Been the Top Sector in Five of the Last Eight Years Since 2008
U.S. fixed-income returns by sector, 2005–16, as of December 31, 2016

Source: Bloomberg Barclays Live and Credit Suisse. Sector returns shown are Bloomberg 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 specific portfolio managed by Lord Abbett 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.

 

Question #3:  Could additional fixed-income investment options inadvertently increase certain factor exposures?
Plan sponsors who are considering adding (or recently have added) a multi-sector or global bond may want to review how “core” the current intermediate-term bond offering actually is because of potential, unanticipated factor bets. The current intermediate-term bond offering may have a stellar track record, but may have achieved that record by investing in the same sectors and securities as their multi-sector or global bond fund. In other words, by adding a global bond fund or multi-sector fund to a menu with an intermediate-term bond fund, a plan sponsor may be increasing exposure to certain sectors. Furthermore, it is important understand how those overlapping sectors may perform should markets enter into a significant risk-off environment. Conversely, it is also interesting to note that of the 94 funds in the Morningstar Multisector Category (screening for multiple fund share classes), the government bond allocation ranges from 0% to nearly 96%, as of January 31, 2017. As a result, a multisector investment option may not offer the intended diversification away from the intermediate-term bond.

Next Steps for Defined Contribution Plan Fiduciaries
Evaluating investment options by using a disciplined process and documenting those decisions are basic tenets of a responsible defined contribution plan fiduciary. When certain market trends persist for extended periods of time, it often is difficult for fiduciaries to remain disciplined and preserve the original objective of the retirement plan investment menu options. Maintaining the right framework for evaluating intermediate-term bond options is critical at any time, but perhaps made more acute in 2017, given the experience of the capital markets in the years following the financial crisis of 2008–09. The three basic questions posed in this article may be a helpful starting point for defined contribution plan sponsors and fiduciaries to evaluate the current fixed-income strategies offered to their plan participants.

 

1 Not all funds in category report statistic.
2 Not all funds in category report allocation.
3 Not all funds in category report allocation.
4 Not all funds in category report.  Some individual bonds may be split rated.  Excludes non-rated bonds.

 

The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).

The Morningstar Multi-Sector Bond represents funds that seek income by diversifying their assets among several fixed-income sectors, usually U.S. government obligations, U.S. corporate bonds, foreign bonds, and high-yield U.S. debt securities.

The Morningstar Intermediate-Term Bond represents funds that focus on corporate, government, foreign, or other issues with an average duration of greater than or equal to 3.5 years, but less than or equal to six years, or an average effective maturity of more than four years, but less than 10 years.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies, including market, liquidity, currency, and political risks. Mid and small cap company stocks tend to be more volatile and may be less liquid than large cap company stocks. Mid and small cap companies typically experience higher risk of failure than large cap companies. Investments in value companies can continue to be undervalued for long periods of time and be more volatile than the stock market in general. These factors can adversely affect Fund performance. No investing strategy can overcome all market volatility or guarantee future results.

A basis point (bps) is one one-hundredth of a percentage point.

Diversification does not guarantee a profit or protect against loss in declining markets.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to ma king an investment decision.

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