DEFINED CONTRIBUTION

The Agg and target date funds:
still the choice?

Mar 7, 2019
By BlackRock

As the fixed income market evolves, plan sponsors are asking: does the Bloomberg Barclays U.S. Aggregate Index still deliver return and diversification for target date fund investors?

The fixed income allocation within a target date fund has two primary functions. It can be a source of return, but its more crucial role may be equity diversification, particularly for participants near or in retirement. Under ideal circumstances, the allocation supplies both; in reality, return and diversification come to the forefront under different conditions.

For example, before the rising rate cycle began in 2015, many plan sponsors were concerned about how interest rate risk might result in bond fund losses, leading some to consider alternatives such as high yield bonds that might add return. On the other hand, stock market volatility at the end of 2018 reminded many investors of the importance of equity ballast within a portfolio.

That’s why we believe alternatives to the Bloomberg Barclays U.S. Aggregate Index (“the Agg”), the most common target date fixed income allocation, need to be measured against the Agg’s return and diversification potential. In a paper published in January 2019, we reviewed a number of alternatives to determine whether there may be more appropriate choices. Here is some of what we found:

Short duration: weaker ballast, lower returns

A flatter yield curve has narrowed the difference in yield between short duration (as measured by the Bloomberg Barclays 1-3 Year U.S. Government/Credit Aggregate Index) and the Agg, but historically, short duration trails the Agg in total return. (See the table at the bottom of the article).

Unfortunately, the loss in yield and return has not been compensated for by improved diversificationThe chart below shows the five quarters with the most severe equity drawdowns over the last few decades, as measured by the S&P 500 Index. It compares the returns for the S&P 500, the Agg and short duration and finds that on each occasion, the Agg offset more of the equity loss.

Historical performance of short duration versus the Agg

Historical performance of short duration versus the Agg

Source: Morningstar Direct, as of 31 December 2018. Returns of less than one year are unannualized. Indices represented include the Bloomberg Barclays U.S. Aggregate Bond Index, ICE BofAML 1-3 Year U.S. Corporate & Government Index, and S&P 500 Index. Past performance is no guarantee of future results. Indexes are unmanaged and one cannot invest directly in an index.

Long duration: better ballast, bumpier ride

As might be expected, there is a strong intuitive case for using long duration within a target date fund for its diversification benefit. A comparison against the Agg for the five worst drawdown quarters, similar to the short duration chart, would show that the Bloomberg Barclays U.S. Long Treasury Index performed substantially better.

Where that case breaks down is volatility; long duration has been as much as three times more volatile than the Agg, as the chart below illustrates. The largest bond fund allocations within a target date glidepath are for people at or in retirement–as much as 60% in LifePath’s retirement vintages. Therefore, long duration may potentially increase volatility just as target date fund investors increasingly value stability.

Comparing volatility between the Agg and long duration

Comparing volatility between the Agg and long duration

Source: Morningstar Direct, as of 31 December 2018. Indices represented include the Bloomberg Barclays U.S. Aggregate Bond Index and the Bloomberg Barclays U.S. Long Treasury Index. Past performance is no guarantee of future results. Indexes are unmanaged and one cannot invest directly in an index.

High yield: sharing
equities’ downside

Adding exposure to credit risk in order to generate greater yield potential also increases the fixed income allocation’s correlation to equities. This can have two consequences for target date funds. The first is that the diversification benefit is reduced when it’s needed most. The result can be seen in the chart below, which compares total return for the Bloomberg Barclays U.S. Corporate High Yield Index against the Agg and the S&P 500 for years in which the S&P posted a loss (from 1986 through 2018).

What’s more, the bond allocation is the primary mechanism target date managers use to control risk across the glidepath. Using high yield may require substantially altering the glidepath, including reducing overall equity exposures, to keep risk consistent with the fund’s objectives.

Average return in S&P 500 down year

Average return in S&P 500 down year

Source: Morningstar. Data as of 31 December 2018. Indices used were the Bloomberg Barclays U.S. Corporate High Yield Index TR USD, the Bloomberg Barclays U.S. Aggregate Bond Index TR USD, and the S&P 500 TR USD to common inception on 1 January 1986. Correlations during the full time period use yearly returns. It is not possible to invest directly in an index. Past performance is not indicative of future results.

International, active and
other strategies

Other alternatives may offer potential benefits – and introduce potential complexities. Unhedged international bonds have been less correlated with many domestic asset classes, making them an attractive consideration. Unfortunately, the currency risk, which is expected to have little to no total return benefit over time, can add considerable volatility. Hedging the currency risk, however, increases its correlation to the Agg.

Active managers may be able to unpack the Agg and pursue a variety of strategies including sector allocation, security selection and duration selection. BlackRock manages active fixed income within custom target fund mandates, but it should be understood that they require additional, highly disciplined management and a rigorous optimization process across all allocations to avoid unintended concentrations of risk.

Clearing a high bar

Ultimately, when it comes to alternatives to the Agg, we ask how likely is a change to improve our ability to generate returns from the target date fund–not just the fixed income allocation–and whether the change increases our certainty of achieving the fund’s objective. Outside of a specialized objective and a robust investment platform with experienced target date management, we continue to believe that broad-based index exposure to the Agg remains an appropriate choice for many target date funds.

Factor awareness, Tactical asset allocation, Rigorous optimization process

Source: Performance and standard deviation from Morningstar Direct. Duration and yield from Bloomberg. Duration is represented by effective duration. Yield is represented by yield to worst. Duration and yield data is as of 31 December 2018. Return and standard deviation data represents the period of common performance inception, 1 February 1990, to 31 December 2018. Indices represented include the Bloomberg Barclays U.S. Aggregate Bond Index, ICE BofAML 1-3 Year U.S. Corporate & Government Index, Bloomberg Barclays Global Aggregate ex USD Hedged Index USD, Bloomberg Barclays U.S. Corporate High Yield Index, and Bloomberg Barclays U.S. Long Treasury Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

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