Rethinking Fixed Income Strategies


  • As the bond market delivers some of its lowest returns in 30 years, many sponsors want to know how to tweak their allocation to manage risk and decrease interest rate sensitivity.
  • Three DC advisors share strategies on helping clients rethink their fixed-income allocation.

The expression, "Can't live with it, but can't live without it" may aptly describe how your clients are feeling about fixed income these days.

With the bond market delivering some of its lowest returns in 30 years and the threat of rising rates looming in the background, many have likely realized that they can no longer rely on core bond strategies. But they know that fixed income can add necessary diversification and help mitigate risk in DC plans.

As a result, many are asking DC advisors how to assess and possibly tweak their fixed income allocations as they seek to enhance diversification, decrease interest rate sensitivity, and manage risk, say top retirement plan advisors.

One team of retirement specialists, Larry Deatherage and Tim Rohkemper from the San Diego-based Retirement Benefits Group, say their clients' interest in rethinking their strategy has led them to change the focus of the conversation from pure fixed income investing to managing risk appropriately.

"At one time, we used to refer to this discussion as managing fixed income portfolios," says Rohkemper. "But today, we don't want to start the conversation by saying, "Ok, here are your 'safe' assets." Instead, we refer to it as 'managing the risk portfolio,' and we frame our conversation around how fixed income can manage risk in a way that equities cannot."

DC Edge spoke to Deatherage and Rohkemper as well as Scott Matheson, Senior Director of Raleigh, NC-based CAPTRUST Financial Advisors to explore how they are helping their clients reposition fixed income portfolios to adapt to today's environment.

"We are in a different part of the interest rate cycle that will likely produce lower returns than some bond investors have been used to." - Scott Matheson, CapTrust.

Three ways to help sponsors rethink their fixed income strategies

1. Start with the basics. Matheson and his team at CAPTRUST recommend that DC advisors start a fixed income discussion by focusing on the rationale for investing in bonds in the first place, and to assess whether that rationale still applies in the current environment.

"Essentially, we believe that little has changed with the long-term benefits of fixed income; we are just in a different part of the interest rate cycle that will likely produce lower returns than some bond investors have been used to," he explains. "When you look at the rationale for fixed income investing, the diversification component is still intact. Bonds have historically served as a hedge in a deflationary environment as well as in periods of capital market stress, providing clients with portfolio stability during inopportune events."

Deatherage and Rohkemper also strive to focus their clients away from "short-term" headlines (such as the Federal Reserve's recent announcement about its intent to taper its bond buying program) to the role of fixed income in portfolios and how to position it appropriately.

For example, last year, when rates rose sharply, some of their clients were looking to add a more actively-managed component to their portfolios to add diversification and complement the Barclay's U.S. Bond Aggregate Index. "We introduced them to the idea of adding unconstrained or more diversified strategies to manage credit, currency or other risks (U.S. or non U.S.) in the fixed income market," says Deatherage.

2. Consider thinking out of the fixed income "box." The three DC advisors believe that strategies that worked during the 30-year bull-run will no longer work today. In circumstances where Matheson and team manage asset allocation models, they are focused on less constrained bond funds, global bond funds, and multi-sector quality funds.

Deatherage and Rohkemper caution their clients about focusing too heavily on shorter duration bonds to address the issue of the decline in the Barclay's U.S. Aggregate Index. "We believe investors generally tend to underestimate the importance of long-term cyclical changes, and place too much emphasis on short-term volatility," says Rohkemper. "We have to view rising rates differently, since the U-curve has two ends. Our clients tend to focus too much on the shorter end, and tend to forget that the longer end of the curve has already priced in the longer-term cyclical changes.

"Our goal is to stress that unconstrained is a complement, not a substitute, to a core bond holding" -Tim Rohkemper, Retirement Benefits Group.

"At the end of the day, if you address the issue of rising rates with short duration investments, you're really not fully solving the issue of how to address the decline in the U.S. Aggregate Index and how position portfolios in a rising rate environment," he continues.

Moving forward, Rohkemper believes clients should focus on the long term and consider positioning themselves to adapt to all kinds of market environments—rising rates or not. "Clients will always want to know how their portfolios will perform in any given year," he says. "The only way we can effectively answer that is by educating them on what happens when portfolios are exposed to certain market scenarios, market risks, and what they can expect on the downside and the upside.

Ultimately, our goal is not to encourage our clients to move in and out of investments," adds Rohkemper. "Rather, it is to help them keep participants invested in their 401(k)s, to allow them to experience these market scenarios (in a positive way) and help them achieve great outcomes because they believe they made the right decision and positioned themselves in the right way."

3. Ramp up communications. In discussions with clients about fixed income, strive to maintain a fine balance between being proactive and stirring up the hornet's nest, advises Matheson. "Our goal is to educate our clients about what's happening, but we don't want to push the panic button and emphasize issues that we don't believe to be acute risks," he explains.

In addition to client presentations and market updates, Matheson does this by developing charts and graphs that demonstrate the historical benefits of various fixed income allocations during past periods of rising interest rates. For example, charts can be used to illustrate asset class or peer group return data of such diversifiers as global bonds both hedged and unhedged to currencies.

Deatherage and Rohkemper also utilize charts to show the impact of historical performance on asset classes, and emphasize risk profiles of various investments for more sophisticated investment committees.

They also develop model portfolios, or custom target date funds, to demonstrate the risk/return impact of blending a Barclay's U.S. Aggregate Index with an actively-managed unconstrained bond fund. "Whether it's a 50/50 or 60/40 allocation, our goal is to stress that unconstrained is a complement, not a substitute, to a core bond holding," says Rohkemper.

Fixed income concerns?

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