Rethinking fixed income. By Trevor t. Oliver

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1 12 Rethinking fixed income By Trevor t. Oliver

2 Summer/Fall 2012 The Participant : Issue 02 ssga.com/dc/theparticipant 13 The landscape for this asset class has changed. Our approach should too. Investors use bonds for two primary purposes: risk prevention and income. Government and high-grade corporate securities, the traditional mainstays of fixed income portfolios, have filled each role potently for the past three decades. These bonds have provided stability and diversification away from equities, while a nearly continuous decline in interest rates has boosted their prices and total returns. The highest-quality bonds will likely continue to serve as an effective counterweight to stock market risk. They are, however, extremely unlikely to continue generating strong total returns. Today s historically low interest rates undercut the current income produced by traditional bond portfolios and simultaneously increase the likelihood that rates will rise and depress bond prices. The new landscape calls for new strategies. For fixed income portfolios to continue providing both risk protection and income, investors must take advantage of the greater yields offered by higher-risk fixed income assets while managing overall portfolio risk through careful, thorough diversification. Holding an extensive range of sectors that offer exposure to different risks, income levels, return potential and correlations is likely to generate a much stronger balance of risk and reward than would be possible through conventional, high-quality assets alone, says David Ireland, CFA, director of U.S. defined contribution strategy for State Street Global Advisors. SSgA is working to achieve that goal. We are analyzing the variety of opportunities and risks presented by income-producing investments. The insight we gain will help us determine the most effective ways to build and maintain fixed income portfolios. Three easy decades for Treasuries Fixed income investors have had the best of both worlds since the early 1980s. The highest-quality bonds have generated only one-third of stocks volatility, as well as low correlations to the equity market, 1 fulfilling their role as a buffer against stock market losses. Meanwhile, interest rates long slide lifted high-quality bonds returns. Intermediate-term Treasuries gained a stock-like 8.5%, annualized, between 1982 and 2011, 2 as the rate on the five-year Treasury fell from 15% to less than 1%. 3 Most participants in today s workforce have never experienced sustained headwinds to their bond portfolios as a result of rising interest rates. Presumably, most participants would be surprised to see losses in their fixed income investments should rates begin to rise. bonds have trailed stocks only modestly since 1982 but stocks returns have been far more volatile. stock returns * bond returns * stock Returns * bond Returns * 12% 40% 30% 20% 10% 0% -10% -20% -30% -40% % 8% 6% 4% 2% 0% 11.0 % 8.5 % * Annualized * Calendar Years 1,2 Ibbotson SBBI 2012 Classic Yearbook. 3 Federal Reserve. Source: Ibbotson Associates SBBI 2012 Classic Yearbook. Stocks represented by the S&P 500; bonds by intermediate-term government bonds. Volatility measured by standard deviation. For illustrative purposes only. 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. Past performance is not a guarantee of future results.

3 14 Rethinking fixed income continued Time for a new take on fixed income Government bond returns have approached those of stocks during the last 30 years, with much less volatility. The scenario of low risk and high returns cannot be repeated during the next 30 years. When rates return to more normal levels, prices of existing bonds will fall. In the meantime, low yields will offer little support for bondholders total returns. Investors can capture higher yields while diversifying away a portion of their risk. But while diversification has been standard practice among equity investors for decades, it is relatively new in the fixed income world. To this point many investors have approached bond diversification using the same tools and methodologies that they apply to stocks, says Ireland. But fixed income has fundamental differences that call for a bondspecific approach. The methods that underlie conventional fixed income benchmarks may make them an imperfect foundation for diversified fixed income exposure, for reasons that include the following: 1. An overemphasis on high-quality assets. Traditional indices, and funds that track them, divide bonds credit quality into two categories: investment grade and high yield. Aggregate indices tend to focus exclusively on the former, with large allocations to Treasuries, investment grade corporate debt and high-rated mortgage-backed securities. As a result, defined contribution plans offer primarily investment grade options, and participants allocate the vast majority of their fixed income assets to investment grade credit. High-quality assets play an important role in controlling certain kinds of risk. But assets farther down the credit spectrum offer diversification, greater yield and the potential to mitigate other risks, particularly those related to interest rates and inflation. As a result, incorporating modest exposure to these lower-quality assets could significantly improve participants return potential without a commensurate increase in overall risk. 2. The perverse effects of issuance weighting. The generally accepted method for constructing fixed income indices is to weight securities by issuance: The more debt an institution issues, the greater its representation in the index. This methodology probably stems from an attempt to mirror market-capitalization weighting in equity indices. But issuance weighting in fixed income benchmarks is problematic, in part because it gives issuers a great deal of influence over their own index weightings. Consider what happens when a troubled entity issues large amounts of debt. The new issuance may cause the entity s weight in the index to increase, leading funds to buy more of its debt at precisely the moment the debt becomes less attractive. It s hard to argue that represents an efficient trade-off of risk and return, says Ireland. 3. Shifting risk exposure. The events of the past few years have significantly altered the composition of fixed income indices. Since 2008 the federal government has flooded the market with new debt, and its securities now make up a larger portion of conventional indices. The result: Investors whose fixed income portfolios mirror the Barclays Aggregate hold more concentrated exposure to certain risks than they did five years ago. In these and other ways, conventional fixed income construction leads to a lack of diversification and, as a result, to inefficient portfolios. The market is ripe for a new approach. Investors diversify broadly at the low end of the capital structure, among equities, says John Keller, senior product engineer for SSgA. We think it makes sense to do the same at the high end of the capital structure, among debt securities. At the very least, we should evaluate the risk and return characteristics of belowinvestment grade credits and consider them for inclusion in portfolios. A more rational method Plan sponsors and their participants would benefit from an approach that segments the fixed income market rationally, based on exposure to discrete risks. Fixed income investors are compensated for taking on particular risks, says Keller. We re working to develop a system that manages exposure to those risk factors.

4 Summer/Fall 2012 The Participant : Issue 02 ssga.com/dc/theparticipant 15 PDF Online extras Read SSgA s paper Silent Migrations Within the Barclays Capital U.S. Aggregate Index to learn about the implications of the changing composition of this index. SSgA proposes the following three-step process for constructing portfolio allocations: 1. Identify a set of risks for which fixed income investors are compensated, such as those related to inflation, interest rates, credit and liquidity. 2. Determine the exposure to each type of risk needed to achieve a particular level of total risk, taking into account diversification among various component risks. 3. Construct portfolios of assets that match the desired exposures. This approach could provide an overall risk level comparable to that of the Barclays Aggregate, with a greater degree of diversification and thus a higher expected return. Better results could elevate the role fixed income plays for participants at all levels of risk preference from simply managing the threat of a stock bear market to contributing meaningfully to their portfolios performance. How fixed income has changed Shifts in the fixed income markets have dramatically altered the composition of bond benchmarks. Consider the percentage of the Barclays U.S. Aggregate each of the following sectors composed at yearend 2007 versus in March 2012: government related 32 % 41 % mortgageand assetbacked 45 % 34 % credit 23 % 26 % Source: Barclays Capital. 12/ / The changes have important implications for portfolio performance. The Barclays Aggregate previously offered a very different balance of exposure to interest-rate risk (through government bonds), credit risk (largely through corporate bonds) and prepayment risk (through mortgage- and asset-backed securities). The shift toward government debt and away from MBS and ABS leaves far more of the benchmark s risk related to changes in interest rates. The impact on participants: Portfolios based on the Barclays Aggregate Index are much more likely to underperform if interest rates rise than they were in the past. They also are less likely to benefit from improvements in the economy, which typically weigh on government bonds. Meanwhile, the emphasis on low-yielding government securities depresses the portfolios potential for total return. Today s defined contribution plans generally offer one or two fixed income funds built using traditional methods. To help participants get the most from their fixed income assets, we need to do more than just offer a greater number of funds: We have to reevaluate the asset class and our approach to it. SSgA is committed to this reassessment. In the months ahead, we will publish research and develop solutions that help plan sponsors adjust to the new reality of today s fixed income markets. P The knowledge gap Many participants realize that low interest rates lead to low returns on money market funds and bonds. But their level of knowledge drops drastically after that. 1 I strongly or somewhat agree that interest rates are low, which means that lower-risk investments, like some bonds and money market funds, are generating lower returns than normal. I understand the term fixed income very well. I understand the term bonds very well. 69 % 43 % 29 % Trevor T. Oliver is a vice president at State Street Global Advisors and director of defined contribution research and product development. He is responsible for the advancement of SSgA s standard DC offerings and the design of custom DC solutions. Participants generally low comprehension of fixed income suggests that plan sponsors and administrators should take the reins by playing an active role in managing risk and identifying opportunities to enhance return. And when communicating with participants, base your message on what a fund does rather than the financial instruments it contains. 1 SSgA Participant Survey, 2012.

5 The Participant Magazine ssga.com/definedcontribution This article is from State Street Global Advisors publication: the participant For more articles like this one, visit Subscriptions: To receive print and/or digital copies of The Participant, please us at or go to and click on subscribe at the bottom of the page. Feedback: We welcome your ideas, your feedback and your suggestions for questions to include in future participant surveys. Send your suggestions to The views expressed in this material are the views of SSgA Defined Contribution through the period ended July 18, 2012, 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. 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. Investing involves risk, including the risk of loss of principal. Diversification does not ensure a profit or guarantee against loss. Risk associated with equity investing includes stock values, which may fluctuate in response to the activities of individual companies and general market and economic conditions. Although bonds generally present less shortterm risk and volatility risk than stocks, bonds contain interest rate risks, the risk of issuer default, issuer credit risk, liquidity risk and inflation risk. Increases in real interest rates can cause the price of inflation-protected debt securities to decrease. Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. 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. DC STATE STREET CORPORATION

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