Global Fixed Income in Defined Contribution Plans

Transcription

1 Lazard Perspectives Global Fixed Income in Defined Contribution Plans US defined contribution (DC) plan sponsors are re-evaluating their fixed income menus in light of today s low yield environment and the perceived threat of rising interest rates. Opportunistic global fixed income solutions are being evaluated by DC plan sponsors to address the pronounced interest rate risk in strategies benchmarked to the Barclays Capital US Aggregate Bond Index. There can be some ambiguity as to where to place a global bond investment option. Is it a stand-alone solution in the plan menu? Is it a component of a target-date fund? Or both? We believe that an allocation to global fixed income can be of benefit to DC participants, with the potential to mitigate home-country bias, as well as provide a favorable long-term pattern of performance, income generation, and diversification.

2 2 Summary DC plan design continues to evolve. Plan sponsors are streamlining the number of funds in the core investment lineup to ease participant decision-making, maximize plan usage, and achieve more successful outcomes. The next generation of DC plan design may include further streamlining toward a handful of risk- or objective-based investment options (e.g., capital preservation, inflation protection) rather than relying on asset class or style-box methods of the past. In the context of discussions regarding the role of fixed-income in DC, global fixed income is emerging as a sensible replacement or complement to a domestic core bond option, as it has the potential to enhance income while still serving a crucial diversifying role. Following a multi-decade downward trend in interest rates and subdued inflation in a number of countries, many fixed income investors today are considering more flexible options. Moreover, many domestic fixed income solutions may track benchmarks with a sizable exposure to low-yielding, government-related securities. In today s low-rate landscape this presents a risk and may hinder plan participants from achieving successful outcomes. We believe global bonds are appealing in this environment, as there are tangible benefits from diversifying bond return drivers (i.e., avoid locking into a single-country interest rate or economic environment). Active management is well-suited for global fixed income. Closely tracking an index can lead to unwanted sector/country concentrations, as well as interest rate risk. Currency volatility is the dominant contributor to the overall volatility of global bond strategies. Hedged global fixed income strategies may be more suitable for plans that are concerned about fixed income volatility and as such, may be more suitable for a stand-alone option. However, we also believe careful currency management in an active solution means unhedged versions can also add value over full market cycles, providing an extra source of returns. Unhedged global fixed income strategies may be more suitable as part of a white label multi-manager stand-alone option, or as part of a custom target date fund. Evolution of DC Plan Design and Investment Options The design of DC plans is evolving with the principal goal of simplifying participants decision making (Exhibit 1). 1 A sizable share of plans are still following a style-box methodology offering equity investment options along the value growth and small cap large cap dimensions. In this structure, fixed income investments are separated, for example, into a core domestic fund and a money-market/stable value solution. A small but growing share of DC plans have already streamlined their lineup replacing the style-box method in favor of asset classes while other plan menus have been further simplified into four or five risk categories or objectives in place of asset classes. These risk buckets can include global equities/fixed income, capital preservation/stability (i.e., money markets, stable value, Treasury Bills), as well as incomegeneration or inflation-protection solutions. In this newer approach, a DC lineup can be composed of four objectives: growth, income, capital preservation, and inflation protection. In turn, each objective can encompass one or more actual funds. The shifts in DC plan design have been gradual given the complexity of plan specifics and the dual need to ease the participant decision-making process while maintaining suitable options for an adequate asset allocation. However, we believe a constant theme has been maintaining an emphasis on devoting deeper analysis to equity solutions while paying less attention to developing a robust fixed income menu. For example, Exhibit 1 DC Plans Have Been Simplified into Four Risk Categories Evolution of DC Plans Asset Style Asset Class Objectives Large Cap Value Large Cap Active/Index Large Cap Large Cap Growth Small/Mid Cap Value Small/Mid Cap Active/Index Small/Mid Cap Growth Non-US Value Non-US Active/Index Non-US Growth High Yield Bonds Other Fixed Income Core Bond Active/Index Small Cap Non-US Equity Core Plus Bond Growth Income Stable Value/Money Market Capital Preservation Capital Preservation Inflation Protection Inflation Protection Inflation Protection Source: Hewitt EnnisKnupp

3 3 many plans have offered non-us equities for a long time, while very few historically have included non-us fixed income. Vanguard s DC plan recordkeeping data a sample of 3,000 plan sponsors and $600 billion in assets indicated that 85% of plans have a stand-alone international equity investment option, compared to only 7% of plans that offer an international fixed income option. 2 As capital markets have become more globalized, fixed income solutions deserve a closer look, particularly in today s environment. In fact, for most countries outside of the, the concept of global fixed income investing has been prevalent for decades, due to formerly shallow local capital markets, and the need to diversify globally in some countries fixed income is also more prevalent compared to equities. In terms of allocation funds and target-date funds, the exposure to global bonds is also minimal. At less than 2%, the exposure to global fixed income is minuscule which contrasts with a larger allocation in foreign equities at around 20% 30%. 3 Product innovation in fixed income is well positioned for solutions in a DC plan context. Recently, solutions have been created to span the risk spectrum from stability to core to high income generation. Traditionally, core fixed income considers only US bonds. However, many fund sponsors are now considering replacing and in other cases complementing core allocations with global fixed income. Hedged versions of global bond strategies sometimes fit better with the characteristics of the stability/core category due to dampened volatility. Unhedged strategies can be found further across the risk spectrum (due to added currency volatility, but also potential returns), located in between core allocations and other risk assets. As such, they may be better suited as part of a multi-manager, white-label fixed income option or part of a custom target-date fund. Benefits of Going Global Fixed income investments have enjoyed a very favorable multi-decade period. Since the 1980s, disinflation and global interest rates trending lower boosted bond performance, especially in the. This tailwind has diminished as nominal interest rates in many markets are near historical lows. In addition, the global macro environment is complex in the face of geopolitical risks, monetary policy uncertainty, and many other factors. However, these complexities may present opportunities to differentiate exposures through country rotation. We have identified three key benefits of global bond investments. 1. Home-country bias can be a missed opportunity. The first benefit of a global fixed income strategy is to diversify economic exposures that drive performance. A bond investor choosing a single country is tied to the interest rate cycle, inflation, yield curve, and monetary policy of that country. Global capital markets are highly integrated and some factors are likely to move in tandem across countries/regions. However, over the medium term, macro factors are likely to diverge. An investor focused locally would be unable to benefit from favorable results elsewhere (Exhibit 2). Home-country bias can prove costly. Exhibit 2 Home-Country Bias Can Hinder Returns Country Performance Local Currency Performance of Select Countries in the Citigroup World Government Bond Index Sweden Italy Japan Canada Norway Sweden Australia Italy Italy Italy Italy Canada Sweden Italy Norway Australia Italy Australia Italy Canada Canada France France Japan Australia France Australia Sweden Italy Canada France Canada Sweden Norway Germany Australia Australia Australia France Canada Canada France Canada France Sweden Norway Italy Australia Germany Canada Sweden Norway Sweden Italy Australia Italy Canada Sweden Norway France France Germany Australia Sweden Norway Germany France Australia France Sweden Germany Germany Germany Italy Australia France Australia Germany Japan France Germany Germany Norway Norway Australia Germany Germany Germany Canada Germany Japan Japan Canada Australia Canada Norway Germany Norway Germany France Australia France Australia Sweden Australia Sweden Norway Germany France Sweden Norway Norway Canada Canada Germany Canada Sweden Italy Japan Norway Norway Germany Sweden Norway Canada Sweden France Canada Japan Japan Japan Norway Italy Norway Canada France France Italy Australia Japan Japan Japan Sweden Germany Japan France Japan Sweden Japan Japan Japan Japan Italy Italy Japan Italy Italy Sweden Japan As of 31 December 2014 The table shows annual total returns of 11 major components of the Citigroup World Government Bond Index Unhedged (WGBI Unhedged), in local currency terms. The WGBI Unhedged covers the most significant and liquid government bond markets, currently including 23 government bond markets, worldwide. Credit: Callan Associates Inc. and the Callan Periodic Table of Investment Returns. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. For illustrative purposes only. This information is not representative of any product or strategy managed by Lazard. Source: Citigroup

4 4 2. Investing globally in fixed income significantly broadens the opportunity set. Global bond markets are deep. The Barclays Capital US Aggregate Bond Index had about 9,000 issues and a market value of $18 trillion, compared to almost double the number of securities (16,000) and 2.4 times the market value ($43 trillion) of the Barclays Capital Global Aggregate Bond Index (as of March 2015). An expanded choice of investments that includes both developed and emerging markets is especially important given the fluid global macro landscape. Keep in mind that the global bond market is significantly larger than what is suggested by the indices Diversification in a portfolio context. While the return pattern of global bonds may differ from US bonds, global fixed income can also provide diversification benefits relative to other assets. Historical correlation of global bonds versus US and global developed markets equities shows that global bonds have been able to maintain diversifying characteristics (Exhibit 3). The hedged version of global bonds tends to closely track US bonds over many periods, with lower volatility. Benefits of Choosing Active Management Countering the Benchmarks Drawbacks In our view, the benefits of a global fixed income allocation for longterm investors are strong. However, passive allocations may not be optimal to access these investments. Passive indices are capitalization weighted; therefore the largest issuers will command the highest weights. For instance, approximately 36% of the Barclays Capital US Aggregate is represented by Treasuries, which grew as a result of issuance in recent years (as of March 2015). This dynamic can lead to unwanted concentrations for index investors. Importantly, bond benchmark characteristics are not static. Yield and duration have moved virtually in opposite directions as a result of monetary easing. That is, yields have trended lower while duration has progressively moved higher. For investors, this means there is more interest rate sensitivity and less compensation via income a dangerous proposition in the current environment. An active approach to global bond investing can help counter many of the benchmarks drawbacks using country/sector positioning and security selection. Active managers are able to diversify country/ sector exposure away from concentrations arising from capitalization weighting. In addition, interest rate risk can be dampened through careful duration management at a local country level. Lastly, active management can potentially add value through selection of out-ofbenchmark securities. Expanded Credit Opportunities As we hinted earlier, the total size of the global bond market is much larger than the subset captured in the indices. Off-benchmark positions drastically expand the opportunity set to source attractive opportunities. Accessing credit, or non-government bonds around the world, has increased in importance as issuance has flourished over the past decade or so, in sectors such as corporate bonds, sovereign external debt, supra-nationals, agencies, and mortgages. The ability to focus on global credit cycles and exploit mispricing of credit spreads between countries and currencies is another tool which can potentially add value versus a purely domestic credit focus (Exhibit 4). An additional benefit from a larger opportunity set is enhanced income, as security selection can increase a portfolio s current yield (coupon divided by price) relative to a benchmark. This is especially important given the trajectory of yields in recent years. In our view, a disciplined approach can add basis points in terms of current yield over a market cycle, in relation to what is attainable from an index. This feature can be attractive for meeting the income requirements of certain DC participants. The Currency Question The foreign currency component of global fixed income can be a source of concern for some investors, because the volatility from bond components (price and coupon) is small compared to the volatility introduced by currency fluctuations. With this in mind, many observers believe that hedged strategies are the only ones warranting a spot in DC plan lineups. In our view, careful currency management means that unhedged versions are also well suited for DC plans especially in light of the low-yield environment, as this extra tool can add value over full market cycles. Exhibit 3 Global Bonds Can Provide Diversification Benefits Relative to Other Asset Classes Correlation of Bond Indices, US, and Global Equities MSCI World Index S&P 500 Total Return Index Barclays Capital Global Aggregate Bond Index Barclays Capital Global Aggregate Bond Index (Hedged USD) Barclays Capital US Aggregate Bond Index MSCI World Index 1.00 S&P 500 Total Return Index Barclays Capital Global Aggregate Bond Index Barclays Capital Global Aggregate Bond Index (Hedged USD) Barclays Capital US Aggregate Bond Index As of 31 December 2014 Data in USD. MSCI World Index includes dividends net of withholding tax. Source: MSCI, Standard & Poor s, Barclays, Bloomberg

5 5 Exhibit 4 Example of Global Credit Opportunities Five-Year Maturity GE Bond Spreads vs. Local Government Bonds (bps) 120 Exhibit 5 Opportunities Related to Currency Exposure Rolling 3-Year Performance, Unhedged minus Hedged (%) Unhedged Outperforms 0 Japan Mexico Europe Canada Sweden Australia As of 2 April 2015 Data show the option-adjusted spread. The securities mentioned are not necessarily held by Lazard for all client portfolios, and their mention should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio. Source: Bloomberg Hedged Outperforms As of 30 April 2015 Unhedged = Barclays Capital Global Aggregate Bond Index; Hedged = Barclays Capital Global Aggregate Bond Index (Hedged USD). The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices above are unmanaged and have no fees. One cannot invest directly in and index. Not intended to represent any product or strategy managed by Lazard. Source: Bloomberg In terms of cumulative long-term performance both versions of the global bond benchmarks are comparable. However, analyses of cumulative returns are subject to the elected start date. As such, looking at rolling returns can shed some light into performance especially entry-point risk. Simply looking at the rolling three-year returns comparing unhedged and hedged indices, we see that performance varies over different market cycles, and these fluctuations may provide opportunities within a global fixed income context especially related to currency exposure (Exhibit 5). In our analysis, the unhedged version outperformed the hedged version in 58% of the monthly observations (each reflecting a three-year rolling return result) since Investors may be influenced by the recent strong dollar trend, but we believe the cycle will ultimately shift again, providing opportunity to profit from currency exposure. We believe it is important to highlight the features of an active approach to currency management. A benchmark s currency exposure is driven by the country/issuer weights. As a result, there is no way for the passive investor to alter this composition. In hedged indices the hedging methodology is passive too and, importantly, indices do not reflect transaction costs. In contrast, an active manager can tailor a strategy s currency exposure and find unique ways to add value to enhance portfolio returns providing the ability to be defensive and opportunistic. Implementation in a DC Context As mentioned previously, the dampened volatility of hedged global fixed income is a more straightforward replacement or complement to a core domestic bond investment option. Based on popular benchmarks, the volatility of USD-hedged global bonds was lower than US bonds, while returns were comparable for the ten years ended in April We believe unhedged implementations are better suited for complementing or blending the fixed income menu toward a more growth-seeking objective. Importantly, we advocate an active approach due to the reasons described in the preceding section and in light of today s macro environment. In addition, DC participants are a diverse group some are still accumulating assets, while others are already in retirement. We believe the characteristics of global fixed income can serve various groups with careful implementation. A hedged version can serve as replacement for domestic core bonds for those both in the accumulation and withdrawal phases. Meanwhile, a partially hedged solution can achieve the income requirements of those withdrawing plan assets (i.e., retirees relying on income). Conclusion We believe that active global fixed income investing offers the potential for an attractive risk/return profile, because of the expanded opportunity set, the possibility to invest in low-correlated and unsynchronized markets, and the ability to add value through currency management. Conversely, a strictly domestic portfolio may severely limit the opportunity set, and ultimately limit the chance of meeting investment goals by being tied to a single economic and interest rate cycle. The current DC plan construction framework has streamlined and reclassified assets into a handful of categories. In this setting, global fixed income is poised to play a more prominent role as a complement or replacement of domestic core bond investment options. Global bonds are also well suited as a component of allocation funds and target-date funds. For long-term DC stakeholders, we believe the characteristics of global bonds are better than a domestic-only approach for the shifting environment ahead, and may improve the potential outcomes.

6 6 Discussing Lazard s Approach to Global Fixed Income Q&A with Lead Portfolio Manager Yvette Klevan Q As an active manager, can you briefly describe your philosophy? We think it s crucial to conduct global macro market and trend analysis. However, we also rely on bottom-up relative value security analysis. Over time, our team has learned how performance can be enhanced by rotating through bond and credit markets, while selectively taking currency risks. Q How do you approach the different sources of return in global fixed income markets (for example, country/sector allocation, duration, currency)? Our investment framework identifies six broad sources Biography Yvette Klevan Managing Director Portfolio Manager/Analyst Yvette Klevan is a Portfolio Manager/Analyst on the Global Fixed Income team. She began working in the investment field in Prior to joining Lazard in 2002, Yvette was a Senior Portfolio Manager with Offitbank. Previously she worked at Bank of America, Chase Manhattan Bank and Aramco Services Company. Yvette has an MBA in Finance and Management Information Systems from the University of Houston and a BBA in Mechanical Engineering Route to Business from the University of Texas. of returns: country allocation, yield curve positioning, duration exposure, sector allocation, security selection, and currency exposure. Our portfolio construction is driven by systematically integrating these sources. Importantly, our methodology is not sequential or static, but dynamic. In practice we continually assess the macroeconomic environment from a global and local perspective, taking into account the impact of capital flows, market positioning, and investor sentiment. We also monitor relative values, from a global perspective (interest rate, credit, and currencies), and unique nuances and factors that drive asset prices for each country. We often avoid overcrowded or consensus ideas, and seek opportunities that other investors may be overlooking. Sometimes we deliberately avoid certain investments due to market conditions or our fundamental outlook. Before implementing any trades, we perform in-house final qualitative research (i.e., liquidity, market positioning) and quantitative analysis (i.e., scenario and break-even analyses, correlations) to fully understand and monitor risk in the portfolios. Q What makes your strategy/team unique? We construct our portfolio with cash bonds. We think this is important for many investors, as implementations with derivatives can introduce basis and counterparty risk. We also think a differentiating feature is that we function as a firm-wide FX advisor helping other Lazard teams with currency analysis and decisions underscoring our depth and expertise in global currency markets. Q Unconstrained global fixed income means many things to many people, ranging from LIBOR- or cash-plus benchmarks with a universe consisting of any country/any sector/any issuer to implementation within an absolute return philosophy. Which do you subscribe to and why? We believe the label unconstrained pertains more to the universe, or opportunity set, and applies to both absolute and relative return mandates. An absolute return orientation relates to how we think about risk management, or risk calibration which may differ from our relative return mandates. Essentially, the investment objective for an absolute return mandate is not to lose money (i.e., generate a positive return). Therefore, we believe it is critical to understand the various layers of risk within the context of risk control. For example, we utilize stop losses on currency exposures since currencies are generally the most volatile part of a global fixed income portfolio. Maintaining a shorter duration, or more defensive interest rate profile, is also part of our risk management process in today s environment, as is monitoring and managing sector/ spread risk. Depending on the market environment, the portfolio holdings and positioning may not necessarily differ from a relative return mandate, but the risk management will likely be very different. We believe it is important to pursue an unconstrained strategy in terms of a flexible global fixed income universe; however, investors should not lose sight of the role that fixed income plays within a total portfolio, especially during periods of risk aversion when duration is an important antidote. The risk of some unconstrained fixed income strategies is that they do not behave like a diversified fixed income portfolio. They are effectively exchanging interest rate risk for high concentrations of credit risk with an increasing correlation to the equity market. Interest rate risk (in a rising rate environment) is more of an opportunity cost. However, with credit risk, a credit event could lead to impairment and the potential to not receive the full notional amount at maturity. Since the term unconstrained is used loosely in the marketplace, we think investors should clearly understand how the manager interprets this to avoid unwanted exposures. Q Do you have any DC plan clients utilizing your strategy? Yes. We have been hired by a corporate DC plan as part of a white-label, multi-manager global fixed income option.

7 7 7 About the Team Lazard s Global Fixed Income team was established in 2002, complementing the firm s renowned investment platforms. The team s philosophy relies on a combination of top-down global market views and bottom-up, relative value security selection, to add value in global bond markets. The team is led by Yvette Klevan and, on average, its members have 15 years of experience in global fixed income investments. Notes 1 What s in a Name: White-Label Funds in DC Plans. Hewitt EnnisKnupp, October How America Saves 2014: A report on Vanguard 2013 defined contribution plan data. Vanguard, June Given that these are US-based data, international would imply countries other than the. We found no specific data points on global investment options. However, our point remains that in fixed income, there are very few plans with the alternative to choose bond investments that are not US-based. 3 Roth, Charles. Global Opportunities: The Next Leap Forward for Defined Contribution Investment Menus. Advisor Perspectives. 6 February As a rough estimate, we relied on data from the Bank for International Settlements (Debt securities statistics, Table 18: Total debt securities by residence of issuer). Using these data, the total amount of debt securities is $89 trillion, as of March For the period April 2005 to April 2015, annualized returns and volatility for the Barclays Capital Global Aggregate Bond Index (Hedged USD) were 4.64% and 2.63%; annualized returns and volatiliy for the Barclays US Aggregate Bond Index were 4.75% and 3.25%. Source: Bloomberg. Important Information Published on 18 May Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Derivatives transactions, including those entered into for hedging purposes, may reduce returns or increase volatility, perhaps substantially. Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. Use of derivatives transactions, even if entered into for hedging purposes, may cause losses greater than if an account had not engaged in such transactions. This material is for informational purposes only. 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