This article is part of our Retirement Plan Trends series, which explores issues affecting the retirement space.

While the stock market and individual stock names usually grab the attention of the public with their headlines and dramatic stories, the fixed income market doesn’t usually provide much by way of surprises. But quietly over time, the Bloomberg U.S. Aggregate (Agg) Index, the primary benchmark for most defined contribution (DC) core bond strategies, arguably has become less diversified. The index’s composition has changed considerably since just after the great financial crisis. U.S. Treasuries now make up 42% of the index, up from 28% in 2009. In addition, rising interest rates and a decline of 13 percent for the Agg Index in 2022 have combined to be significant developments in the bond market, sparking some DC plan sponsors to review how they offer fixed income options in their investment menus. 

Core bonds in today’s DC menus

DC menus are designed to provide the appropriate building blocks and solutions for participants to either select or create a portfolio to meet their particular investment objectives. DC participants are allocating to fixed income to achieve objectives such as income, inflation protection, diversification from equities and capital preservation, but the balance of those goals changes depending on a participant’s timeline to retirement. Of the 15 to 20 options typically offered (target date series would be counted as one option), perhaps only 3 or 4 options might be fixed income, including stable value and money market funds. In reality, fixed income options in DC plans are dominated by core fixed income, which is most often benchmarked to the Bloomberg U.S. Aggregate Index, according to Capital Group’s 2023 Institutional Retirement Survey of Plan Sponsors.

Relative to the universe of opportunities within fixed income, thinking beyond core could add significant value. Over the past 20 years, there has been considerable differentiation of results among fixed income sectors.

Sectors like high-yield debt (BB/Ba and below) and emerging markets debt have the potential to impact a fixed income portfolio’s return, yield and risk metrics. With the change in the rate environment, industry-wide capital market expectations have also significantly changed. Higher yields mean fixed income potentially may offer higher expected returns than in the previous decade while continuing to provide lower risk (standard deviation) than equities, and diverse characteristics. With this change in expectations, different fixed income strategies have the potential to be utilized more effectively to align with a portfolio objective. For example, with higher starting yields, below investment-grade (BBB/Baa and above) and emerging markets debt may provide enhanced levels of income in a portfolio context. 

The case for active

From an investment perspective, a case could be made for active management in the fixed income space. With inflation expected to fall and the U.S. Federal Reserve evaluating rate cuts, the bond landscape is looking much clearer. Within many DC menus, core fixed income options often are active-only, unlike large-cap equity, where passive strategies are more prevalent, Capital Group’s 2023 Institutional Retirement Survey of Plan Sponsors revealed. 

While core fixed income options can provide effective fixed income exposure, plan sponsors may be asking themselves if there are even more effective ways of achieving fixed income objectives for DC participants by expanding the opportunity set for bond funds in the plan. For active fixed income managers, the current environment presents a host of opportunities from duration and yield curve positioning, to security selection within corporate and securitized bonds. In addition, active managers are able to expand opportunities not only in security selection but within sectors that have attractive outlooks such as emerging markets bonds. Plan sponsors offering only a passive fixed income option in the lineup should consider not only the diversification of the index but also the ability of skilled investment managers to potentially add value over the index. Active managers can provide a higher level of diversification relative to the Agg, including consideration of spread sectors.

For some of the larger well-resourced plans, plan sponsors could create a custom white label option. White label solutions, which are constructed by putting together a diversified portfolio of strategies, may provide a better fixed income option to achieve multiple participant objectives. A white label option might combine Agg index exposure with allocations to additional sectors that are not in the Agg index, such as high-yield corporate debt, emerging markets debt (EMD) and U.S. Treasury Inflation-Protected Securities (TIPS). 

When designing a white label fixed income option, plan sponsors could draw inspiration from their plans’ asset allocation solution. Target date investments, for example, can alter the fixed income portfolio as participants approach retirement with more of a focus on income and capital preservation. Focusing on these objectives within a diversified fixed income portfolio may be beneficial to older participants who are close to retirement with higher allocations to fixed income while not disadvantaging younger participants, who tend to have lower exposure to fixed income overall. 

Based on Capital Group’s capital markets assumptions (CMAs) and an efficient frontier made up of stocks and bonds, one can see the potential benefits of including high yield, EMD, and TIPS for individuals with higher fixed income allocations. The CMAs, developed by Capital Group’s analysts, make assumptions for returns and volatility (standard deviation) for the next 20 years. (Note that the estimates are not guarantees of future results and do not include the impact of any fees or active management of the investments. Also keep in mind that higher returning asset classes generally also come with greater risk, which diversification may be unable to eliminate.)

The potential impact of plus sectors for older investors

For participants in and near retirement, who typically have relatively light equity allocations, adding fixed income sectors beyond the core can be especially impactful. Not only could it increase the yield (income) of the portfolio, it could potentially create a higher expected return portfolio per unit of risk. For investors far from retirement, adding extended sectors to an equity-core bond portfolio may have little impact on either expected risk or return, simply because younger investors tend to have much smaller fixed income exposure.

This is shown in the above chart, which compares return and volatility assumptions (standard deviation) for two equity-bond portfolios — one that has bond exposure consisting of core bonds only (Agg), and another with bond exposure that’s a combination of core, EMD, TIPS and high-yield debt (Agg+). Depending on the mix of bond and equity exposure, the Agg+ portfolio can provide a higher assumed return than the Agg portfolio without adding significant volatility. For example, compare a portfolio with 85% exposure to Agg+ to one with 75% in core-only bonds (Agg); the former portfolio has a higher assumed return (despite its lower equity exposure) but similar assumed volatility. As equity is added to the portfolio moving right along the x-axis, the potential benefit from the extended sectors declines. 

The appropriate balance between equity, core bonds and extended sectors within any portfolio will differ based on the plan demographics or a participant’s needs and objectives, and results will vary depending on the fixed income and equity returns that each investor experiences. However, we believe this hypothetical analysis demonstrates the potential benefit of adding appropriately sized exposures beyond the Bloomberg U.S. Aggregate Index, especially for investors in and near retirement.

For some plan sponsors, white label options may not be a feasible solution due to time and resource constraints. In that case, sponsors should focus on how fixed income is offered to participants as a stand-alone off-the-shelf option. Passive options that focus on low fees and low tracking error (deviation from the benchmark) can provide broad market exposure for participants. However, these strategies may be limited in their ability to take positions that differ meaningfully from the Agg. As a result, plan sponsors could consider broader fixed income mandates that include professionally managed allocations to diversifying areas of the bond market. 

Key considerations for plan sponsors

The good news is that the fixed income decline in 2022 did not cause participants to make significant asset allocation changes. The Investment Company Institute reports that only 8% of DC participants changed their asset allocation following 2022 compared to 11.8% in 2009 after the great financial crisis. 2023 brought stronger returns for bond markets in general, but now may be an ideal time to evaluate fixed income options for both diversification and the potential benefits of active management to help participants build DC portfolios.

Suggested next steps

 

• Evaluate white label fixed income options that can provide a more diversified and holistic approach for a participant’s fixed income allocation. This could:
  • Improve diversification across fixed income markets for participants.
  • Potentially help individuals in and near retirement by increasing portfolio yield and expected return per unit of risk without disadvantaging those with longer horizons/higher equity exposure.

• Consider actively managed fixed income portfolios to expand the opportunity set and potentially add value through security selection, credit and duration management as market conditions evolve. This can:
  • Create greater alignment with investor objectives (such as equity diversification and/or income) than an index-tracking investment vehicle designed to represent a universe of securities.
  • Result in greater sector diversification and risk management than an index-tracking investment vehicle that may become more concentrated in government securities.