It’s what you learn after you know it all that counts.

—John Wooden

One of my earliest career responsibilities was managing municipal bond settlements. This included checking signatures and counting bearer bonds in the basement of the California State Treasurer’s office in Sacramento, bringing the multimillion-dollar settlement check to the closing, and then distributing the bonds to syndicate members who, in turn, would deliver them to investors, often retirees.

Unlike today, at the time municipal bonds had a series of coupons attached that allowed the investor to literally clip a bond coupon and then redeem it for the promised payment of interest on the bond. In the 1980s, these municipal securities often paid over 8 percent interest pretax—with an assumed tax rate of 25 percent, this equates to a tax equivalent yield of nearly 11 percent. Not bad! For a retiree, buying a ladder of municipal bonds with maturity dates spread out perhaps over a decade offered a fixed and steady income. This approach to buying bonds built a fixed income for the retiree.

Today, fixed-income investing continues to be at the center of retirement investing, although many aspects have changed:

• Investors are more likely to buy into a bond mutual fund or other pooled vehicle rather than buying individual bonds . . . and coupons are no longer clipped from bearer bonds but rather are electronically paid out to the registered owners.
• Retiree assets are likely invested via a tax-deferred account such as a DC plan or IRA . . . in which the tax advantages of municipal bonds are negated, and taxable fixed-income securities are more attractive (note that municipal bonds continue to be a popular retiree investment choice for after-tax accounts).
• Bond markets now exceed $100 trillion globally and have evolved to offer more choice and opportunity for investors who seek to improve risk-adjusted returns.
• Yields have dramatically fallen from when 401(k) plans were first established, requiring investors to develop new approaches to fixed income—and plan sponsors to take a fresh look at DC plan offerings. (Figure 6.1 provides an overview of the history of interest rates and DC plans in the United States.)

As discussed in Chapter 3, fixed income is a primary risk pillar in DC plans—one that has been present in plans since inception. In PIMCO’s 2016 Defined Contribution Consulting Support and Trends consultant survey, respondents unanimously supported the inclusion of fixed-income offerings within the investment lineup. Yet many raise questions such as “How many fixed-income offerings and what types are appropriate for DC investors? Should the offerings be available as stand-alone core investment choices or included as part of blended strategies such as white label/multimanager core or custom target-date/risk strategies?”

While the term fixed income is often used synonymously with the term bonds, technically, fixed income includes bonds with maturities of 12 years or longer, notes that have maturities of between 1 and 12 years, and money market instruments maturing in at least 1 year. In Chapter 5, we considered capital preservation alternatives including stable value, money market, and short-maturity fixed-income strategies. In this chapter, we’ll investigate the important role other types of fixed-income securities can play in DC plans. We’ll also consider the bond strategies DC plans offer today, what additional types of bonds may add value in plans, and how plan fiduciaries may evaluate these strategies. Finally, we review why active bond management is so important—recall that in Chapter 3, we noted that among the consulting firms surveyed in 2016, not a single one recommended a passive-only approach to bond management.

As one of the largest fixed-income investment managers in the world, PIMCO offers a wealth of education on bond investing at www.pimco.com. We’ll draw upon this material to provide an overview of the bond market, as well as guidance on the importance and types of bonds.

WHAT ARE BONDS, AND WHY ARE THEY IMPORTANT FOR RETIREMENT INVESTORS?

A bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments, corporations, and municipalities issue bonds when they need capital. An investor who buys a government bond is lending the government money. Likewise, an investor who buys a corporate bond is lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time, known as the bond’s maturity date.

The modern bond market was born in the early twentieth century, when governments began to issue bonds more frequently, and as the market developed and evolved, investors have purchased bonds for three principal reasons: capital preservation, income, and diversification.

• Capital preservation: Unlike equities, bonds repay principal at a specified date absent default, which is their maturity. This feature makes bonds appealing to investors who do not want to risk losing capital, as well as to those who must meet a liability at a particular time in the future. In addition, bonds also offer interest at a set rate that is often higher than short-term savings and money market rates.
• Income: Most bonds provide the investor with “fixed” income. On a set schedule—whether monthly, quarterly, twice a year, or annually—the bond issuer sends the bondholder an interest payment, which can be spent or reinvested. Stocks can also provide income through dividend payments, but stock dividends tend to be smaller and less frequent than bond coupon payments. Companies also make stock dividend payments at their discretion while bond issuers are contractually obligated to make coupon payments.
• Diversification: Including bonds in an investment portfolio can help diversify the portfolio. Many investors diversify among a wide variety of assets, from equities and bonds to commodities and alternative investments, in an effort to enhance the long-term risk-adjusted returns of their portfolio.

Diversification across stocks and bonds is effective because stocks and bonds have typically been low or negatively correlated—so when one is not doing well, the other tends to. Bonds typically do well during economic slowdowns, while equities do not, and vice versa. This is typically most evident during a “flight to safety” event when the stock prices fall dramatically, leading investors to pull their money out of stocks and put them in bonds, which are considered safer assets. During these times, bond prices rise because of increased investor demand.

One additional and important potential benefit to investors—price appreciation, also known as capital appreciation—emerged as the bond market became larger and more diverse in the 1970s and 1980s, when bonds began to undergo greater and more frequent price changes.

• Capital appreciation: Bond prices can rise for several reasons, including a drop in interest rates and an improvement in the credit standing of the issuer. If a bond is held to maturity, any price gains over the life of the bond are not realized; instead, the bond’s price typically “reverts to par” (its original value) as it nears maturity and the scheduled repayment of the principal. However, by selling bonds after they have risen in price, and before maturity, investors can realize capital appreciation on bonds. Capturing the capital appreciation on bonds increases their total return, which is the combination of income and capital appreciation. Investing for total return has become one of the most widely used bond strategies over the past 40 years. (For more, see the section on “Bond Investment Strategies” later in this chapter.)

WHAT ARE THE DIFFERENT TYPES OF BONDS IN THE MARKET?

As noted above, the modern bond market began to evolve in the 1970s, when the supply of bonds increased, and investors learned there was money to be made buying and selling bonds in the secondary market and realizing price gains. Until then, however, the bond market had primarily been a place for governments and large companies to borrow money. The main investors in bonds were insurance companies, pension funds, and individual investors seeking a high-quality “landing spot” for money needed for some specific future purpose.

As investor interest in bonds grew in the 1970s and 1980s (and faster computers made bond math easier), finance professionals created innovative ways for borrowers to tap the bond market for funding, and new ways for investors to tailor their exposure to risk and return potential. The United States has historically offered the deepest bond market, but Europe’s market has expanded greatly since the introduction of the euro in 1999, and more recently, developing countries that are undergoing strong economic growth have become integrated into the global bond marketplace.

Broadly speaking, government bonds and corporate bonds remain the largest sectors of the bond market, but other types of bonds, including mortgage-backed securities, play crucial roles in funding certain sectors, such as housing, and meeting specific investment needs. It’s important to understand that any time there is a risk that a borrower may not repay as promised, for example, by failing to make a payment or fully repaying a loan, there is credit risk. The degree of credit risk varies depending on the issuer, for example, corporations, mortgage borrowers, municipalities, or foreign governments. Independent credit rating services assess the default risk, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate risk, but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.

• Government bonds: The government bond sector is a broad category that includes sovereign debt, which is debt issued and generally backed by a central government. Examples of sovereign government debt include Government of Canada Bonds (GoCs), U.K. gilts, U.S. Treasuries, German bunds, Japanese government bonds (JGBs), and Brazilian government bonds. The United States, Japan, and Europe have historically been the biggest issuers in the government bond market.

A number of governments also issue sovereign bonds that are linked to inflation, known as inflation-linked bonds or, in the United States, Treasury Inflation-Protected Securities (TIPS). In Chapter 8, we take a closer look at inflation-linked securities.

In addition to sovereign bonds, the government bond sector includes subcomponents, such as agency and quasi-government bonds, which allow central governments to pursue various specific goals such as supporting affordable housing or the development of small businesses. Some agency bonds are guaranteed by the central government while others are not. Local governments—whether provinces, states, or cities—also borrow to finance a variety of projects, from bridges to schools, as well as for general operations. The market for local government bonds is well established in the United States, where these bonds are known as municipal bonds. European local government bond issuance has grown significantly in recent years.

• Corporate bonds: After the government sector, corporate bonds have historically been the largest segment of the bond market and this market is evolving rapidly, particularly in Europe as well as in many developing countries.

Corporations borrow money in the bond market to expand operations or fund new business ventures. Corporate bonds fall into two broad categories: investment-grade and high-yield (also known as junk) bonds. High-yield bonds are issued by companies perceived to have lower credit quality and higher default risk than more highly rated, investment-grade companies. Within these two broad categories (investment grade and high yield), corporate bonds have a wide range of ratings, reflecting the fact that the financial health of companies can vary significantly. While a high-yield credit rating indicates a higher default probability, higher coupon payments on these bonds aim to compensate investors for the higher risk.

• Emerging market bonds: Sovereign and corporate bonds issued by developing countries are also known as emerging market (EM) bonds. Since the 1990s, the emerging market asset class has developed and matured to include a wide variety of government and corporate bonds issued in major external currencies (including the U.S. dollar and the euro), as well as in local currencies (often referred to as emerging local market bonds). Because they come from a variety of countries, all of which may have different growth prospects, emerging market bonds can help diversify an investment portfolio—and can potentially provide attractive risk-adjusted returns.
• Mortgage-backed and asset-backed securities: Another major area of the global bond market comes from a process known as securitization, in which the cash flows from various types of loans (mortgage payments, car payments, or credit-card payments, for example) are bundled together and resold to investors as bonds. Mortgage-backed securities (created from the mortgage payments of residential homeowners) and asset-backed securities (created from car payments, credit card payments, or other loans) are the largest sectors involving securitization.

After an issuer sells a bond, it can be bought and sold in the secondary market, where prices can fluctuate depending on changes in economic outlook, the credit quality of the bond or issuer, and supply and demand, among other factors. Broker-dealers are the main buyers and sellers in the secondary market for bonds, and DC participants typically purchase bonds through mutual funds or other pooled strategies such as collective investment trusts or separately managed accounts.

WHAT TYPES OF BONDS SHOULD BE OFFERED TO DC PARTICIPANTS?

Now that we know what type of bonds make up the majority of the market, which type of bond strategies should be offered to DC participants? After all, participants are not investing in individual bonds, but rather mutual funds or other pooled vehicles.

As discussed in Chapter 3, what’s important in structuring a DC menu—whether lengthy or brief—is to offer a risk-balanced investment set. In the event that participants evenly divide their assets across the investment menu (i.e., the naive rule or 1/n portfolio strategy), the result should provide a reasonably balanced portfolio (Figure 6.3). Many DC plans offer just one U.S.-centric bond choice, which can lead to equity-heavy allocations by participants. Plan sponsors may find many participants benefit when offered a balanced ratio between stock and fixed-income options, including the capital preservation option, to ensure that investors implementing a naive diversification strategy have a balanced portfolio. While there is no rule of thumb, a 3:2 ratio of stock to bond options would match the commonly referenced 60/40 portfolio.

So what options should plan sponsors offer? In PIMCO’s 2016 Defined Contribution Consulting Support and Trends consultant survey, nearly all consultants (98 percent) recommend a core or core-plus strategy as a stand-alone investment option (Figure 6.4).

In addition, consultants at the median would offer one more bond strategy on the core lineup; they suggest plan sponsors consider income-oriented strategies such as investment-grade corporate bonds, high-yield, multisector, and foreign/global bonds (hedged or unhedged). Blended white-label or custom target-date/risk strategies, core or core-plus, high-yield, and multisector strategies are recommended by over 70 percent of consultants. In addition, foreign or global (unhedged), unconstrained, investment-grade credit, and emerging-markets bonds (unhedged) are suggested by over 60 percent of consultants. Notably, over half of consultants (55 percent) also recommend that long-duration bonds be included in blended strategies. This addition may be most appropriate for the long-dated vintages of target-date strategies.

We’ll look at each of these most-recommended strategies in turn to review the goals and benefits to DC investors.

Core and Core-Plus Bonds

The most-recommended bonds strategy for DC plans, core fixed-income strategies are offered by the vast majority of DC plans and, given their limited volatility and downside risk, are often viewed as the “anchor” of a portfolio. Some plans offer a core bond strategy that is passively managed or tightly tethered to the Barclays U.S. Aggregate Index (BAGG), or a “core-plus” bond strategy that adds some discretion to add other instruments—such as high yield or global debt—for greater risk-adjusted returns. (The Barclays U.S. Aggregate Index is composed of U.S. government, corporate, and securitized debt.)

Core strategies provide investors the potential for benefits of capital preservation, income, and diversification, plus these strategies have potential capital appreciation. However, because these strategies are often tethered to the Barclays U.S. Aggregate Index, the low-rate environment (Figure 6.5) that PIMCO expects to persist for some time at time of writing will drag on expected returns (because, as we will discuss later in this chapter, a portfolio’s yield typically accounts for 80 to 90 percent of future return). As such, we agree with consultants that more, higher-returning bond strategies should be considered for core menus.

INVESTMENT-GRADE AND HIGH-YIELD CREDIT

The second and third most-recommended bond strategies from consultants for stand-alone plan options are investment-grade and high-yield credit (see Figure 6.4). As discussed previously, corporate credit falls into two broad categories: investment-grade and high-yield bonds. Investment-grade bonds are issued by companies perceived to have higher credit quality and lower risk of default than high-yield rated bonds. However, given the additional risk they represent, high-yield bonds have (unsurprisingly) a higher yield than investment-grade bonds.

The potential benefits of this asset class for participants include higher expected returns than core bond strategies, as well as the overall diversification benefits presented by bonds. While these strategies are typically more volatile (and have higher drawdowns—or the peak-to-trough declines during a specific recorded period—than core bond strategies), at the same time they have historically displayed lower volatility than U.S. equities, and thus offer a nice balance between the two. In today’s environment, the income from corporate credit is also meaningfully higher than dividends from U.S. stocks, as shown in Figure 6.6, which illustrates and compares the yields on various asset classes.

Foreign/Global

Investing globally in fixed income can help plan members reach common retirement goals through the potential for higher returns, greater diversification of risks, and inflation hedging. Global bond strategies invest in all bond markets, including the United States, while foreign bond strategies invest in all global bond markets except the United States.

As capital markets have deepened around the world, the U.S. share of the global fixed-income market shrank to only 37 percent at the end of September 2015, according to data from the Bank for International Settlements. Just as U.S. companies have focused overseas to capture broader, global sources of growth, so too should DC plan participants turn their focus globally—as the vast global bond market presents opportunities to enhance returns and reduce overall portfolio volatility. Figure 6.7 illustrates the scope of the opportunity that may be available from “going global.”

BOND INVESTMENT STRATEGIES: PASSIVE VERSUS ACTIVE APPROACHES

Plan fiduciaries can choose from many different investment strategies, depending on the role or roles they desire bonds to play in the DC plan.

The next decision is whether to utilize passive or active management. In passive bond strategies, or index funds, portfolio managers typically only buy and hold bonds, changing the composition of their portfolios if and when the corresponding indexes change. They do not generally make independent decisions on buying and selling bonds. Passive approaches may suit investors seeking some of the traditional benefits of bonds, such as capital preservation, income, and diversification, but they do not attempt to capitalize on changes in the interest rate, credit, or market environment. The most common bond index in U.S. DC plans is the Barclays U.S. Aggregate Index, or BAGG, which invests in government, securitized, and corporate bonds (see Figure 6.8 for a more detailed breakdown).

Active investment strategies, by contrast, try to outperform bond indexes, often by buying and selling bonds to take advantage of price movements. These strategies have the potential to provide many or all of the benefits of bonds, including capital appreciation in excess of their index benchmark. However, to outperform indexes successfully over the long term, active investing requires the ability to: (1) form opinions on the economy, the direction of interest rates, and/or the credit environment; (2) trade bonds efficiently to express those views; and (3) manage risk. Bringing all of these elements together is challenging in the best of times.

One of the most widely used active approaches, mentioned earlier in this chapter, is known as “total return” investing, which uses a variety of strategies to maximize capital appreciation, while retaining bond-like risk profiles. Active bond portfolio managers seeking price appreciation try to buy undervalued bonds, hold them as they rise in price, and then sell them before maturity to realize the profits—thus ideally implementing the advice to buy low and sell high. Active managers can employ a number of different techniques in an effort to find bonds that could rise in price. These include:

• Macroeconomic analysis: Portfolio managers use top-down analysis to find bonds that may rise in price due to favorable economic conditions, interest-rate environment, or global growth patterns. They will look at economic factors such as national output (GDP), inflation, unemployment, and monetary and fiscal policies to determine which countries offer the most favorable investment potential.
• Credit analysis: Using fundamental bottom-up credit analysis, active managers attempt to identify bonds that may rise in price due to an improvement in the credit standing of the issuer. They will look at factors such as a company’s balance sheet, cash flows, use of capital, business model, competition, and quality of the management team. Bond prices may increase, for example, when a company chooses to reduce the debt on their balance sheet or develop a product or competitive advantage that allows them to gain market share.
• Duration, or interest rate, management: To express a view on and help manage the risk in interest-rate changes, portfolio managers can adjust the duration, or interest-rate exposure, of their bond portfolios. Managers anticipating a rise in interest rates can attempt to protect bond portfolios from a negative price impact by shortening the duration of their portfolios, possibly by selling some longer-term bonds and buying short-term bonds. Conversely, to maximize the positive impact of an expected drop in interest rates, active managers can lengthen duration on bond portfolios.
• Yield-curve positioning: Active bond managers can adjust the maturity structure of a bond portfolio based on expected changes in the relationship between bonds with different maturities, a relationship that is illustrated by the yield curve. While yields normally rise with maturity, this relationship can change, creating opportunities for active bond managers to position a portfolio in the area of the yield curve that is likely to perform the best in a given economic environment.
• Roll down: When short-term interest rates are lower than longer-term rates (known as a normal interest-rate environment), a bond is valued at successively lower yields and higher prices as it approaches maturity or “rolls down the yield curve.” Thus a bond manager can hold a bond for a period of time as it appreciates in price and sell it before maturity to realize the gain. This strategy has the potential to continually add to total return in a normal interest-rate environment.
• Sector rotation: Based on their economic outlook, bond managers invest in certain sectors that have historically increased in price during a particular phase in the economic cycle, and avoid those that have underperformed at that point. As the economic cycle turns, they may sell bonds in one sector and buy in another.
• Technical market analysis: Portfolio managers can analyze the changes in supply and demand for specific asset classes or individual bonds, as these changes may cause advantageous price movements.
• Derivatives: While derivatives developed somewhat of a negative association during the financial crisis, when they were used to create leverage, many managers have been able to effectively use futures, options, swaps, and other derivatives in portfolio management. Furthermore, with the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and the evolution of central counterparty clearinghouses, the regulatory framework has reduced risk for select derivatives. In mutual funds and ETFs, derivatives are most typically used for substitution of physical securities and risk control. Derivatives can be more liquid and have lower transaction costs than certain physical securities, in which case it can be better to use them as a substitute for cash bonds. They can also be used to “hedge out” undesired risk characteristics in a portfolio—which means that derivatives (a “risky” asset) can be used to actually lower the overall risk profile of the portfolio.

As you can see, there are many potential ways for active bond managers to enhance returns and reduce risk for DC participants. Given these many techniques, it’s not surprising that active bond management dominates in DC plans and, as noted earlier, that consultants believe active bond management is important. As shown in Figure 6.9, DC plans tend to offer active, rather than passive fixed-income strategies.

As shown in Figure 6.10, passive intermediate-term bond strategies underperformed active core and core-plus strategies over the past five and 10 years. Without doubt, passive bond management typically offers lower expense ratios than active strategies. Nonetheless, reduced returns and exposure to rising rates may hit participants with significantly higher hidden costs. In contrast, active core bond managers can manage risk while seeking to increase returns relative to their benchmark over time and during most market downturns.

For investors in actively managed strategies, this can mean one important thing: the potential for more assets at retirement. Consider that during the past 28 years, the active bond strategies with the most assets in 401(k) plans collectively on average outpaced the BAGG Index, including during periods of rising rates (see Figure 6.11). Indeed, $100,000 invested in these active managers in May 1987 would have grown, on average, to $645,757 by 2015. If it had been invested in the BAGG Index only, however, it would have grown to just $622,689—or a difference of just under $24,000. The best-performing active strategies returned more.

Of course, while active management has the potential to result in higher returns than a passive investment over the longer term, investors should expect active managers to periodically underperform passive ones. It is for this reason that a manager’s risk management program is of critical importance. A robust risk management program will help guide and monitor the risk profile of a portfolio so that it aligns with the manager’s and investor’s expectations. It involves the evaluation of investment risks present in a portfolio and forecasting how the portfolio might behave in different market environments (i.e., “stress testing” a portfolio). An active manager also must evaluate trades on the basis of the risk/reward trade-off. In other words, a trade may have a high return potential but at a risk to the portfolio that is too great for the targeted risk profile of the strategy.

Of course, managers do not have to choose either active or passive. Instead, some plan sponsors offer both active and passive bond options, that is, a “mirror” approach. As noted in Chapter 3 (Figure 6.12), however, the majority of consultants in PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey (83 percent) advised against mirroring fixed-income offerings, as the sentiment is that doing so can create unnecessary communication and selection complexity for participants.

What about lessons from the field? In a November 2009 DC Dialogue we spoke with Kevin Vandolder, CFA, principal and leader of the DC research practice area at Aon Hewitt Investment Consulting (formerly principal at Ennis, Knupp & Associates), about fixed-income investing. He shared the following observations on active fixed-income management:

[T]here are several arguments that support active management of bonds. First, not all segments of the bond market are included in the major bond indexes (e.g., nondollar and bonds rated below BBB), and these segments can provide opportunities for active managers to diversify and tactically outperform the indexes. Secondly, fixed- income markets tend to be somewhat segmented and no market index adequately captures the full range of opportunities available to active managers. Therefore, active managers, and particularly “core-plus” managers with significant skill, can add value. Core-plus managers are managers who opportunistically invest in segments of the fixed-income market that are not included in the major bond indexes, including high-yield and nondollar bonds. Overall we believe that the optimal mix for a particular client depends on factors such as risk control preferences, the desired number of platforms provided to participants, the client’s level of confidence in active management and the client’s sensitivity to investment manager fees.

Vandolder went on to discuss the types of bond offerings plan sponsors were adding to their plans, saying: “Over the last 18 to 24 months, more of our clients have added a complementary fixed-income alternative into their DC plans. The two highest-frequency additions we see to the DC investment option structure are TIPS alternatives and core-plus bond alternatives (e.g., adding in high-yield, non-U.S. fixed income, etc.).”

Today consultant interest in adding diversifying fixed-income options continues as plan fiduciaries seek opportunities for enhancing returns, improving diversification and reducing risk.

ANALYTIC EVALUATION: COMPARING BOND STRATEGIES

What are the evaluation criteria that plan sponsors might use to evaluate different bond strategies and managers? Here we suggest four:

• 1. Return Expectations: What return expectations should plan sponsors have for different bond strategies and managers? To answer this critical question, we suggest evaluating the return potential of current and potential plan offerings by looking at the yield-to-maturity (YTM). Although YTM is an incomplete measure of the total return potential of bond strategies, it may be used as a good first step to comparing indexes and different bond strategies as, over long horizons, it explains 85–90 percent of returns.
• 2. Diversification: Does the bond strategy and/or manager offer diversification benefits relative to other asset classes, such as stocks, diversifiers, or other fixed-income strategies? To determine this, we recommend looking at correlations. The lower the correlation with stocks and other asset classes already on the menu, the greater value the strategy and/or manager will likely add.
• 3. Downside Risk or Loss Potential: Managing volatility to offer a “smooth ride” and limit the magnitude of potential losses for DC participants may reduce fear and flight (i.e., shifting assets out of a strategy) in rougher markets. To determine what the downside risk might be in various market environments (that is, what type of loss participants might expect), we suggest assessing the volatility and the value-at-risk (VaR) at a 95 percent confidence level (VaR estimates the minimum expected loss at a desired level of significance over 12 months), or using similar appropriate downside risk measures.
• 4. U.S. rate exposure: Is your bond strategy sufficiently diversified to reduce exposure to U.S. interest rate risks? As previously discussed, there is a very large global bond market that offers participants a vast opportunity set. We propose plan sponsors consider nominal duration, both overall and U.S.-specific. Based on our index analysis, low duration, and the blended index of global credit, high-yield and Emerging Markets bond strategies all offer lower duration-risk potential than the BAGG.

As you can see in Figure 6.13, there are typically trade-offs when comparing different bond strategies. For example, a low-duration strategy will have lower duration (exposure to interest rates) than a core strategy, which leads to lower estimated volatility and potential drawdown. However, it also has a lower yield to maturity. Likewise, a multisector strategy may provide a higher yield to maturity than a core strategy, but it also has a higher estimated volatility and potential drawdown. Figure 6.14 provides another view of the potential risk-reward trade-off of various approaches.

OBSERVATIONS FOR FIXED INCOME ALLOCATION WITHIN TARGET-DATE STRATEGIES

In Figure 6.15, we present a comparison of the total and breakout of the nominal fixed income allocation between the Market Average and Objective-Aligned Glide Paths. The total allocation identifies the top-level allocation to fixed income as an asset class, while the breakout allocation identifies the specific type of fixed income that makes up the overall allocation. On average, the total allocation to nominal fixed income across the vintages is about equal at 23.6 percent and 23.1 percent respectively. However, compared to the Market Average Glide Path, the weighting to nominal fixed income for the Objective-Aligned Glide Path is slightly higher in the early vintages (e.g., 40 years from retirement comparing at 13.0 percent versus 9.2 percent) and lower in the closer to retirement vintages (e.g., 0 years to retirement at 43.0 percent versus 48.7 percent).

When we consider the breakout of allocations within nominal fixed income, we see more differences. The Market Average Glide Path has a higher allocation to cash and U.S. fixed income, while the Objective-Aligned has a greater weight in long treasuries, global bonds, and high-yield bonds. Neither has a significant allocation to emerging market bonds. As we consider a real (i.e., inflation-adjusted) liability framework, adding more diversifying bonds such as long treasuries, global, and high-yield offers the opportunity for improved risk-adjusted returns and better alignment to PRICE. In the upcoming chapters, we’ll take a closer look at the allocation to the allocation to equities, and inflation-hedging strategies.

The Objective-Aligned Glide Path favors long-duration bonds across the vintages. Understanding risk not as volatility or loss of capital, but instead as lack of income in retirement, the emphasis is steadily shifted toward liability- aware asset classes. This aims to reduce tracking error relative to PRICE (refer to Chapter 2 for an in-depth discussion on PRICE), which ultimately serves to preserve purchasing power. At the individual asset class level, we see lower U.S. fixed income in the Objective-Aligned Glide Path across the board compared to the Market Average. Again looking through the lens of PRICE, domestic credit has a relatively high correlation to equities, and a low correlation to PRICE. The focus of the objective-aligned construction is to increase the correlation to PRICE, especially nearing retirement, not to increase equity beta to seek solely higher returns.

IN CLOSING

The challenges of strengthening bond lineups in DC plans can be complex, but needn’t be overwhelming. We suggest looking first at the current mix of investment options and ways to improve it. This may lead sponsors to replace suboptimal solutions, possibly money market funds and passively managed core bond strategies. It also may prompt sponsors to offer more choices, either as stand-alone core menu offerings or blended within a custom core strategy. As you consider your core, we suggest that fiduciaries model the potential effects of adding or combining solutions.

In the end, there may be no correct answer to the question of how many offerings should be on a DC plan’s investment menu. The “correct” number depends on many factors. But if sponsors can offer a range of options consistent with the needs of plan participants, and present them in a way that reduces the risk of naive diversification, these actions may go a long way toward helping employees achieve their retirement savings goals.

QUESTIONS FOR PLAN FIDUCIARIES

1. What role do you want bonds to play in your investment lineup?
2. Does your current investment lineup have sufficient bond options relative to the number of stock options offered? What would the allocation of a “1/n” investor look like?
3. Which fixed-income strategies complement or complete your lineup?
4. If you offer stable value, would certain fixed-income strategies raise wrap provider concerns?
5. What management style—active or passive—makes the most sense for the fixed-income options on your plan?
6. For income-oriented investors such as near-retirees or retirees, do you offer a bond option that is income-oriented?
7. Given the size of the global bond market, do you offer sufficient access to foreign bonds?
8. Have you evaluated the benchmarks used by your bond investment options—and do they continue to provide the risk-return profile that you are expecting?