Fixed Income Investing: What s an Investor to Do?

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1 INSIGHTS Fixed Income Investing: What s an Investor to Do? July , Rocaton Investment Advisors, LLC

2 Executive Summary As interest rates have fallen steadily over the past 20 years, total-return oriented fixed income investors, such as defined benefit plans, defined contribution plans and endowments, have enjoyed strong fixed income returns with modest volatility. However, as interest rates appear to be headed towards or are at a secular trough and credit spreads are at or near historical averages, traditional core fixed income investors may have to lower their return expectation from this point forward. Certainly, given the current low level of interest rates, it is difficult to envision a scenario that is favorable for the traditional fixed income investor (defined as an investor who is primarily benchmarked to the Barclays Aggregate Bond Index ( Barclays Aggregate )). Without losing sight of other key objectives of a total return fixed income investor liquidity, capital preservation, diversification to equities, and income Rocaton believes that there are ways to adjust fixed income allocations or benchmarks to better position fixed income portfolios for the future. These changes include modifying the typical benchmarks used, investing in opportunistic and/or unconstrained strategies versus benchmarkaware strategies and allocating capital to complementary market sectors with higher yield premiums. Moving from Barclays Aggregate based mandates involves risk in that investors may look very different than their peers and may also be taking on greater credit and liquidity risk; however, the headwinds facing traditional fixed income strategies are significant. We recommend that total return investors at a minimum reconsider whether their current fixed income investment structure continues to be appropriate given their long term risk and return objectives. 1

3 What has changed for total return fixed income investors? For many total return institutional and retail investors, U.S. investment grade fixed income allocations have generally been implemented through investments that track the Barclays Aggregate. While this benchmark ebbs and flows with issuance trends, which are often unrelated to investor objectives, the Barclays Aggregate continues to represent the broadest and most popular measure of the taxable U.S. investment grade fixed income opportunity set. Figure 1: Barclays Aggregate June 2002 June 2012 Characteristics Yield to Worst 5.3% 2.0% Duration 4.3 years 5.1 years Credit Quality AAA/AA+ AA+/AA Sector Allocations Treasury 21.0% 36.0% U.S. Government-Related 13.0% 6.6% Other Government-Related 3.2% 4.1% Corporate 22.5% 20.6% MBS Pass-through 36.5% 30.6% Source: Barclays Capital Other Securitized 3.9% 2.1% That said, we do not recommend that fixed-income investors be tied to a particular benchmark simply because it represents the broadest opportunity set. Looking at a quick snapshot of the Barclays Aggregate today and 10-years ago can provide valuable insight into just how much things have changed in the fixed income market. The most notable change is that the yield-toworst has fallen approximately 330 basis points since June 2002 to 2.0%, which is lower than current and expected inflation rates. Duration on the index has also lengthened more than a We do not recommend that fixed-income investors be tied to a particular benchmark simply because it represents the broadest opportunity set. half-year as a result of falling interest rates, methodology changes by Barclays and additional issuance of longer dated bonds. A closer examination of the underlying sectors provides a picture of what exactly investors are buying when allocating to products that track this traditional fixed income benchmark. The most notable change has been the 1,500 basis point increase in exposure to U.S. Treasuries which is largely the result of increased government borrowing during and after the credit crisis of In addition to the weight of 36% to U.S. Treasury debt, investors benchmarking to the Barclays Aggregate have an approximate 73% exposure to debt explicitly or implicitly guaranteed by the U.S. government. The U.S. government-related weight, which includes taxable municipals and other government-backed bonds, represents nearly 7% and the MBS pass-through exposure, which is largely represented by allocations to Fannie Mae and Freddie Mac, represents another 31%. What can investors expect in the future? As already mentioned, the current low rate environment suggests that, absent additional declines in interest rates, investors are likely to experience only modest nominal returns, 2

4 and possibly worse real returns in the future. Even with the possibility of further interest rate declines, annualized returns over the next three years are still likely to be below 4%. The analysis shown in Figure 2 depicts several interest rate scenarios for the Barclays Aggregate over 1- and 3-year time frames. For investors with longer time horizons, prospective returns are only marginally better. Based on Rocaton s June 30th capital markets forecasts, over the next-10 years we are projecting an annualized return of 3.0% for core fixed income. In addition to lower expected returns, investors may not be getting compensated for taking on interest rate risk. As discussed earlier, the duration on the Barclays Aggregate is near an all-time high. This extension in duration, combined with current low interest rates, and the possibility that rates may rise, suggests that volatility for core fixed income may increase. In addition to a lack of compensation for interest rate risk, yield spread levels on many fixed income sectors are close to or below their long-term historical averages. Given the often non-normal distribution of spreads, investors may not be getting appropriately compensated for taking on additional credit risk. Figure 2: Barclays Aggregate Scenario Analysis 1 Year Time Frame Change in Nominal Interest Rates basis points basis points No Change basis points basis points Expected Total Return 6.7% 5.0% 2.1% -1.7% -5.7% 3 Year Time Frame Change in Nominal Interest Rates basis points basis points No Change basis points basis points Expected Total Return 3.2% 2.7% 2.1% 1.4% 0.7% Data as of 6/30/12. Returns for periods greater than one year are annualized. Reinvestment rate of 1.98% based on 6/30/12 yield. Sources: BondEdge Analytics; Barclays Live Assumes no change in credit spreads. These are forward looking expectations which may not be realized. How should investors respond? Despite what appears to be a bleak outlook for total return fixed income investors, Rocaton believes there are a number of strategies which investors can pursue which could potentially shift the risk/return landscape more in their favor without forsaking the strategic role of core Rocaton believes there are a number of strategies which investors can pursue which could potentially shift the risk/return landscape more in their favor. fixed income. We offer the following three approaches: (1) The first method would be to simply re-define the benchmark. Re-defining the benchmark can be accomplished by reweighting the components of the Barclays Aggregate by choosing a weighting scheme that addresses an investor s objectives with respect to expected return and risk tolerance. Investors could, for example, determine the appropriate allocations to corporates, mortgages and government bonds, rather than tying these allocations to the level of issuance in each sector. An additional way to re-define the benchmark would be to adopt one of the several, fairly recently launched indexes designed to address some of the issues resident in traditional market capitalization weighted benchmarks such as the Barclays Aggregate. Alternative benchmarks include those that use a GDP or fiscal strength weighted 3

5 methodology rather than a traditional capitalization weighted methodology. While these alternative benchmarks reduce exposure to highly indebted issuers, another notable impact with these types of benchmarks is that they typically require a global fixed income allocation, rather than a U.S.-only allocation. (2) A second approach would be to consider unconstrained or more opportunistic multi-sector bond strategies alongside of or in place of the more common benchmark-aware strategies which investors typically hold. A typical strategy in this space has wide latitude in the types of investments and interest rate risk assumed in the mandate. While these types of mandates are generally designed with a goal of outperforming the Barclays Aggregate over a full market cycle, they are likely to experience higher volatility in doing so. (3) A third approach to potentially improving upon a traditional fixed income portfolio would Figure 3: Potential Options for Total Return Core Fixed Income Investors Approach Positives Maintain Current Exposure Simple Traditional Approach Reweight the Barclays Aggregate Return/risk characteristics can be customized to investor objectives Eliminates index drift Adopt an Alternative Benchmark Mitigates bias to highly indebted issuers Opportunity set for return is increased Implement Unconstrained Bond Strategies Not tied to a benchmark Broad opportunity set Generally designed to outperform the Barclays Aggregate over-time Seek Complementary Strategies Higher return and income potential Diversifies duration risk Timely Negatives Exposure dominated by U.S. Treasury debt Future returns likely to be sub-optimal More cumbersome to construct Requires re-evaluation with some frequency Not as easily implemented Generally requires a global fixed income allocation Allocations to emerging markets can lead to higher volatility Objectives vary by product Typically, higher fees Less liquid Higher fees Often requires longer-time horizon and patience on part of investor Examples Traditional core fixed income strategies Custom benchmark construction GDP weighted benchmarks Fiscal strength weighted benchmarks Opportunistic and/or unconstrained bond strategies High Yield/ Bank Loans Emerging Market Debt Private Placements Non-Agency MBS be to diversify via dedicated allocations to less traditional, complementary fixed income markets. This approach involves supplementing the core with strategies that de-emphasize duration risk in favor of idiosyncratic, credit and/or liquidity risk risks which one could argue are better compensated in today s environment. These strategies involve more targeted sectors of the market rather than the broad ranging unconstrained approaches discussed earlier. Examples of these types of strategies include corporate private placements, non-agency mortgage backed securities and below investment grade credit. Figure 3 above summarizes potential options for fixed income investors, although a more in-depth conversation on each approach is warranted before implementing any changes. 4

6 Conclusion Of course, there is always the option to maintain the status quo, which arguably is the path of least resistance and could be the safest option in the sense that it is the one to be most widely followed by peers. While this scenario is potentially a disappointing one in terms of total return and income, we recognize that the implementation of the aforementioned strategies requires additional education and dedication of plan sponsor resources as well as the potential assumption of additional types of risk, such as illiquidity. That said, investors looking to potentially improve upon a traditional fixed income portfolio should consider some or all of the approaches mentioned throughout this paper. Rocaton is registered as an investment adviser with the U.S. Securities and Exchange Commission. Rocaton s Form ADV, Part 2 is available upon request. The information included in this publication has been taken from sources considered reliable. No representations or warranties are made as to the accuracy or completeness of this information and no responsibility or liability (including liability for consequential or incidental damages) is assumed for any error, omission or inaccuracy in this information. This information is subject to change over time. This publication is not intended as investment advice. Before acting on any information contained in this material you should consider whether it is suitable for your particular circumstance. Any opinions expressed in this publication reflect our judgment at this date and are subject to change. No part of this publication may be reproduced or redistributed in any manner without the prior written permission of Rocaton Investment Advisors, LLC. 5