Shifting Ground: Looking Ahead for Fixed Income
Is fixed income shifting in a way that can undermine what participants hope to achieve through their core bond fund investment? An argument can be made that this is the case.
For the past three decades, conditions have been nearly perfect for core bond funds benchmarked to the Barclays Aggregate Bond Index. Since 1980, rates have drifted steadily lower from their post-World War II high, driving bond prices higher and boosting core bond fund total returns. Lately, however, the environment has shifted. Rates have been at historic lows and a growing consensus believes that at some point, they will start moving in the other direction.
Evidence of the powerful effect interest rate movements can have on bond funds was seen in May and June 2013, when interest rates rose and the Barclays Aggregate fell 3.5%. While the Index did rebound from the jolt, the question has become not whether rates will rise, but how – steadily, quickly, or with sudden shifts back and forth. Different scenarios provide different challenges, and depending on their convictions about what's ahead, portfolio managers are looking down the road and asking where returns are to be found.
According to Matt Rauseo, a Senior Investment Strategist within BlackRock's Defined Contribution team, there are a number of compelling stories being told about potential sources of return. Various managers are describing approaches that introduce greater flexibility regarding duration, credit quality, and sectors.
"It makes sense," he says. "Done in a careful, intelligent way, a manager may be able to find returns in a rising rates environment." He cautions, however, that switching to a strategy that adds some exposure to high yield, foreign or emerging market debt does not entirely solve the problem. Many such strategies are still benchmarked to the Barclays Agg and much of their return is still explained by the index.
More to the point, adding asset classes in an attempt to compensate for the declining return potential of the benchmark misses the point, he believes. "When it comes to DC plans, the core bond fund story shouldn't be about returns. It should really be a risk story."
Safety First: The Purpose-Driven Menu
Let's return to our original questions: what do participants expect from a core bond fund? A disconcerting clue can be gleaned from one survey that found as many as 65% of DC participants do not understand that they can lose money in a bond fund. Even participants with a more realistic assessment of investment risk turn to fixed income funds for safety and income, especially when they are near or in retirement.
The problem is that thirty years of robust core bond fund returns may have skewed even intelligent investor's perceptions about the risk of fixed income investments. Participant expectations about bond funds create a potential fiduciary concern for plan sponsors in a rising interest rate environment. Simply put, participants do not understand the risk (and likely reduced returns) with fixed income, while plan sponsors and their investment managers are expected to know better.
Rauseo believes that managing risk, especially in the light of participant expectations, should be first and foremost in plan sponsors' minds when responding to the changing fixed income landscape. Being mindful of risk, however, does not mean that a conservative approach tied to what we have done in the past is the right response. In fact, it seems very clear that the "same old core bond fund" is not going to deliver what participants are looking for.
"What needs to be understood," Rauseo explains, "Is that a flexible approach to fixed income does not necessarily mean greater risk. The bottom line is that the risks participants are exposed to now are different than they were over the last decades, even though their expectations from their core bond funds remain the same."
He suggests that changes made to investment policy statements to better align with the new world of fixed income need to consider the following:
- Having some flexibility to respond to market conditions and opportunities may help a portfolio manager maintain a more diversified set of risks than a fund pegged strictly to the Barclays Aggregate.
- With that in mind, plan sponsors should reconsider whether their participants are best served by a fixed income fund benchmarked to the Barclays Agg, or to a fund with a specific risk and return mandate.
- Expanding the mandate by decoupling from the Agg may allow for a wider opportunity set. Asset classes, credit qualities and geographies that they may not have considered in the past can also help deliver risk management and return potential.
- Rigorous risk management coupled with a dynamic portfolio construction process that adjusts the portfolios risk exposures to both help improve return and more importantly mitigate risk.
Rauseo points to an unconstrained fixed income strategy as an example of a flexible approach that can offer lower risk than the Agg. He warns, however, that plan sponsors should not add new asset classes to their core fixed income funds without fully understanding what their objective is and how it will be implemented.
"BlackRock has a culture of risk management," says Rauseo, "And a culture of fixed income risk management in particular. It's really part of our corporate DNA."
A granular understanding of sources of risk is necessary, including whether the sources are domestic or global interest rates, domestic or global credit, inflation, real estate, and so on. The risk of actively managing at least a portion of the fixed income portfolio needs to be evaluated. A new flexible approach that can move across asset classes and regions requires building a range of risk and return assumptions that should be put through stress tests and scenario analysis. There are far more moving parts involved than a core bond fund that simply follows a benchmark.
For those plans who have the scale should consider a white labeled unitized fixed income fund with an allocation to a flexible fixed income fund. "Our modeling indicates that an addition of flexible fixed income to a core portfolio can diversify risks while improving prospects of returns," explains Rauseo. "For plans who do not have such scale, we understand some third party trust products are being launched that provide commingled access to these types of blended strategies."
An additional consideration is how the change to the stand-alone core bond fund will be communicated to participants - and whether or not the new approach should be applied to the fixed income allocations within multi-asset class solutions such as target date funds.
The important thing to recognize is that change is happening – no matter how you respond. "The fixed income ground is shifting under our feet," says Rauseo. "Standing still is impossible. What makes sense is to get out ahead of the changes, before rates start moving, and put a plan into place that can provide the risk management and potential returns participants want from their standalone core bond funds."