The Case for a Custom Fixed Income Benchmark. ssga.com/definedcontribution REFINING THE AGG

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1 The Case for a Custom Fixed Income Benchmark ssga.com/definedcontribution REFINING THE AGG

2 For decades, the Barclays US Aggregate Index (the Agg ) has been a popular benchmark for core bond investment options offered by defined contribution plans. The Agg is an issuance-weighted index, meaning its composition is weighted in direct propor tion to the actual dollar value of securities that currently exist in the marketplace. In theory, such an approach should provide well-diversified exposure to the investment grade bond market as a whole. But an issuance-based approach inherently tilts the benchmark towards the most indebted borrowers and can, at certain points in the market cycle, result in unintended concentration risks for plan participants. As a result, there are times when a bond index designed to be the stable foundation on which many fixed income retirement portfolios rest actually can become misaligned with the goals of the investors it was intended to protect. Owing in large part to the unprecedented fiscal and monetary policies that have skewed the fixed income markets since the global financial crisis (GFC), the Agg now contains several concentration risks at the high end of its historic range. In this paper, we explore and measure the risks present in the Agg today, including the risks posed by longer durations, lower yields and higher levels of US Treasury-related debt, and the negative impact they could have on total returns if and when interest rates begin to rise. We are by no means the first to point out these problems. But where others have argued for scrapping the Agg in favor of higher-fee actively managed bond funds, we resist the temptation to bag the Agg, and instead put forth a solution which is constrained to the same investment universe but reweights the sector and term structure through strategic asset allocation; preserving the low-cost nature of passive investing while providing an opportunity to strategically evolve as market conditions change. Such an approach, we maintain, can provide better risk management in a broader range of market conditions. KEY QUESTIONS FOR PLAN SPONSORS TO CONSIDER What is the role of fixed income for participants? What potential risks exist in the Agg? What other solutions exist to meet the fixed income needs of participants? State Street Global Advisors Defined Contribution 3

3 Refining the AGG The Role of Fixed Income for Participants QUICK LOOK GL0SSARY Duration A complex calculation formulated in years that measures interest rate risk. The longer the duration, the higher the interest rate risk and adverse impact to rising interest rates. Interest Rate Risk The risk that a change in interest rates will negatively impact a bond s price and correspondingly its total return. Concentration Risk The risk that too much exposure to one sector of the market will negatively impact an overall portfolio. Yield The expected income return from a bond or bond mutual fund, expressed as a percentage of a bond s market price or a mutual fund s net asset value (NAV). Fixed income plays a crucial role for participants of all ages. Participants in the accumulation phase may rely on the diversification that fixed income strategies provide relative to equities. Even participants with decades until retirement can benefit from a small allocation to a core fixed income strategy to help smooth out the ups and downs of the equity markets. Participants in the distribution phase, meanwhile, may count on fixed income for the actual income it provides, and so frequently look to reduce its interest rate risk while enhancing its income and total return potential as they shift a greater portion of their portfolios toward bonds and away from equities. Because fixed income functions as a core holding for participants of all ages, a core bond fund in a DC plan menu ideally should be designed to help participants balance risk across a broad range of market conditions. One of the chief ways that plan sponsors traditionally have tried to accomplish this is through issue-weighted index funds. In addition to providing participants with the broadest possible market exposure, such an approach may offer the appeal of low costs and transparency. Choosing index funds also means that sponsors can spend less time and resources on reviewing and monitoring performance, as is typically required with selecting active managers. However, while issuance-weighted indexes do a good job of replicating the broader market, their diversification, as measured by sector weights and term structure, can vary dramatically during different parts of the market cycle, introducing new sets of risks that can undercut their diversification and staying power. Policy Risk the risk that a change in government policy will negatively impact an investor s bond holdings. 4

4 Risks in the Agg Today Following the financial crisis, fiscal and monetary policy actions to stem the crisis led to a pronounced issuance of US government-backed bonds. At the same time, a flight to safety among investors pushed bond yields to historic lows. This, in turn, caused government agencies and other issuers of new debt to issue longer-term debt to lock in the lower borrowing rates. But what s good for bond issuers isn t necessarily good for bond investors. And as the Agg has shifted post-the financial crisis, investors seeking security of principal may have inadvertently stumbled into other risks in the marketplace, including longer maturity bonds, greater concentration risk and lower yields. When analyzing the Agg, two important characteristics we consider are income and interest rate exposure. In evaluating these characteristics as part of a broader investment review, we typically look at yield-to-worst, which measures the lowest potential yield that could be received on a bond without the issuer actually defaulting, and duration, a common measure of interest rate risk. As illustrated in Figure 1, when we examine the changes in yieldto-worst and duration for each of the various sectors within the Agg during the past decade, several observations appear: The duration of the Agg has extended by almost 25%. More than a third of the exposure in the Agg is now to US Treasury debt. The overall yield on the Agg has declined dramatically. Historically, changes in interest rates have been the largest drivers of return for the Agg. The issuance of longer maturity bonds combined with today s low rates has pushed duration in the Agg to its highest level in 10 years, greatly heightening the risk to total return if rates begin to rise. As more plan sponsors have become aware of the risks this poses to participants fixed income returns, some have begun to look at updating plan menus by replacing strategies benchmarked to the Agg with a more diversified core bond holding. Figure 1. Yield and Duration Comparison Yield-to-Worst Duration (years) Percentage of Index Sector Change Change Change Aggregate Index (1.7) Treasury (1.8) (0.7) Gov t Related (1.1) (5.8) Securitized (1.6) (7.9) Corporate (1.2) Source: Barclays As of December 31, 2013 and 2003 Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. State Street Global Advisors Defined Contribution 5

5 Refining the AGG Figure 2. Barclays US MBS Index Declining Coupon and Extending Duration (December 2003 December 2013) Duration Yield to Worst (%) Duration (LS) Yield to Worst (RS) Source: Barclays, as of December 31, Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. 6

6 The Challenge for Plan Sponsors The question is what should they replace it with? Plan sponsors trying to replace a core bond fund in their plan investment menus may feel that their only other option beyond an issuance-weighted benchmark strategy is an actively managed fund. This can create a conundrum. While it may make sense to choose an active manager, active strategies are rarely as transparent or attractively priced as a comparable index-based strategy. What s more, the squeeze on yields present in today s market has affected actively managed strategies as well. Many active managers, particularly if they are limited to buying investment-grade liquid securities, are finding it harder to beat the Agg on a consistent enough basis to offset the fees they are charging. However, plan sponsors do have another option: to choose a fixed income strategy that is designed and reweighted to better withstand market conditions. Plan sponsors who include target date funds in their plans already will be familiar the with the value that strategic asset allocation and using index-based building blocks can bring to a retirement savings program. At State Street Global Advisors, we have extensive experience managing passively implemented fixed income mandates. Drawing on that experience, we set out to construct a balanced, diversified, stand-alone core bond fund offering, which is reweighted to reflect the realities of today s fixed income market, while retaining the ability to strategically reweight sectors as market conditions change. Additionally, inspiration for making over the Agg came from our creation and oversight of the target retirement funds, drawing on best practices developed in designing custom benchmarks. State Street Global Advisors Defined Contribution 7

7 Refining the AGG An Inside Look at our Custom Fixed Income Benchmark In creating the benchmark for our stand-alone bond fund, we had two key objectives: lowering duration and interest rate risk, while making relatively modest and sensible refinements to the sector allocation to better balance the Treasury, mortgage and corporate bond exposures. Here s how we went about it. Interest Rate Risk To help manage interest rate risk, we ve adjusted duration in our custom benchmark to be more in line with historical averages for the Agg. Concentration Risk SSGA Custom Benchmark The Agg Difference Duration The custom benchmark is made up of securities that are part of the US Agg benchmark but are re-weighted at a sector level across government, corporate and agency sectors. To lower the concentrated government (especially Treasury) weight in the Agg and provide more sector balance, we ve reduced exposure to the government sector, while increasing exposure to the investment grade corporate sector SSGA Custom Benchmark (%) The Agg (%) Difference (%) Government Credit The custom benchmark is made up of securities that are part of the US Agg benchmark but are re-weighted at a sector level across government, corporate and agency sectors. Managing Government Policy Risk To further reduce exposure to the government sector, we ve also reduced our weight to mortgage-back securities (MBS) and other securitized bonds backed by government agencies. Managing Duration Extension Risk To reduce duration risk, we ve underweighted sectors with longer durations. For example, any future rise in interest rates could lead to substantially longer durations within the MBS sector, so our custom benchmark reduces exposure to government MBS while increasing exposure to commercial mortgage backed securities (CMBS) as a lower-duration alternative. SSGA Custom Benchmark The Agg Difference MBS CMBS/ABS The custom benchmark is made up of securities that are part of the US Agg benchmark but are re-weighted at a sector level across government, corporate and agency sectors. Key Characteristics of Our Custom Benchmark By making modest adjustments to the Agg, we expect our custom benchmark to offer comparable expected returns with lower expected risk. SSGA Custom Benchmark The Agg Difference Expected Return (%) Forecast Risk (%) Sharpe Ratio Yield to Worst (%) Duration Option Adjusted Spread (BPS) Expected Return and Forecast Risk are based upon estimates and reflect subjective judgments and assumptions. There can be no assurance that developments will transpire as forecasted and that the estimates are accurate.the custom benchmark is made up of securities that are part of the US Agg benchmark but are re-weighted at a sector level across government, corporate and agency sectors. SSGA Custom Benchmark (%) The Agg (%) Difference (%) Government Securitized The custom benchmark is made up of securities that are part of the US Agg benchmark but are re-weighted at a sector level across government, corporate and agency sectors. 8

8 Learn More While many plan sponsors intuitively understand the importance of regularly reviewing and updating equity choices in their plan menus, some plan sponsors haven t paid as much attention to the fixed income side of their menus. Similar to core equity, core fixed income offerings need to be regularly monitored and reviewed to ensure that they are meeting the needs of participants and the objectives of the plan. More aggressive and more conservative options should be reviewed together to ensure that there are no gaps in the fixed income lineup. If the lineup currently has an investment strategy based on the Agg, it s a good idea to understand how the current sector allocations may have changed since the strategy was first introduced to the plan. In the course of such a review, plan sponsors may find thatw an alternative to an issuance-based approach, along the lines of the one described here, can help participants maintain a low-cost, diversified approach to investing and better meet their retirement goals even in challenging interest rate environments. At State Street Global Advisors, we can help you evaluate whether your current fixed income investment choices are meeting your objectives and the needs of your participants and if not, how to go about fixing them. For Institutional Use Only. Not for use with the Public. If the lineup currently has an investment strategy based on the Agg, it s a good idea to understand how the current sector allocations may have changed since the strategy was first introduced to the plan. State Street Global Advisors Defined Contribution 9

9 For more than three decades, State Street Global Advisors (SSGA) has been on a mission to help our clients and the millions who rely on them achieve financial security. With more than $2.4 trillion* in assets, we partner on a daily basis with many of the world s largest and most sophisticated investors, providing a disciplined, research-driven investment process and powerful global platform spanning asset classes across the indexing and active spectrums to help them reach their goals. SSGA is the investment management arm of State Street Corporation. * This AUM includes the assets of the SPDR Gold Trust (approx. $30.1 billion as of September 30, 2014), for which State Street Global Markets, LLC, an affiliate of State Street Global Advisors, serves as the marketing agent. Please note that AUM totals are unaudited. Learn More For more information about SSGA s DC capabilities and investment strategies, definedcontribution@ssga.com. ssga.com/definedcontribution Investing involves risk including the risk of loss of principal. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGAs express written consent Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. Diversification does not ensure a profit or guarantee against loss Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise bond values and yields usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. The views expressed in this material are the views of SSGA Defined Contribution through the period ended September 30, 2014, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. Barclays POINT/Global Family of Indices Barclays Inc. Used with permission SSGA Target Date Fund are designed for investors expecting to retire around the year indicated in each fund s name. When choosing a Fund, investors should consider whether they anticipate retiring significantly earlier or later than age 65 even if such investors retire on or near a funds approximate target date. There may be other considerations relevant to fund selection and investors should select the fund that best meets their individual circumstances and investment goals. The funds asset allocation strategy becomes increasingly conservative as it approaches the target date and beyond. The investment risks of each Fund change over time as its asset allocation changes. Asset Allocation is a method of diversification which positions assets among major investment categories. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss. The Custom Benchmark is created by SSGA and may be different for different accounts. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. The calculation method for value added returns may show rounding differences. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information State Street Corporation. All Rights Reserved. ID2381-DC Exp. Date: 11/30/2015