Capital Ideas^™ 
Investment insights from Capital Group

When it comes to target date funds, it seems like the equity allocation gets all the attention. Certainly, there are good reasons for this: Equity is responsible for the bulk of the capital appreciation that determines retirement sufficiency.

But in the critical transition and retirement phases, fixed income plays several essential roles that make target date funds such a powerful tool for retirement savings. Fixed income allows target date funds to adjust to varying risks as participants age. As a result, it’s important that financial professionals examine a series’ approach to fixed income and understand how it interacts with equity across the glide path.

The four roles of fixed income

The financial risks relevant to an investor change as they age. Early in their careers, they may fail to accumulate enough to reach their retirement goals; as they approach retirement, a bear market may inflict losses with insufficient time to recover. A diversified bond portfolio can help address these risks thanks to the way bonds interact with equities. Bonds should play different roles within a target date series at each stage of the glide path.

 

• Diversification from equity: Early in the glide path, a modest allocation to conservative bonds with low or negative correlation to stocks can help dampen market risk from equities, which make up the bulk of target date assets at the start of a participant’s career.
• Income: As participants approach retirement, they are more sensitive to market risk and need to generate income. They need bonds that can generate strong total returns and good yield with modest risk.

• Inflation protection: Inflation-linked bonds can protect purchasing power as the overall equity allocation (a source of long-term inflation protection) steadily declines through the typical glide path.
  
• Capital preservation: In retirement, high-quality, low-duration bonds can partially insulate participants from market and interest rate risk — which can ultimately help improve participant outcomes.
  

There are three main issues financial professionals should consider when evaluating a series’ approach to fixed income: Whether the strategies are passively or actively managed, the composition of sub-asset classes held and the ability to use bottom-up manager flexibility to help control various risks.

The pros and cons of active vs. passive

It’s no secret that smart people throughout the industry have very different opinions when it comes to using passively managed vs. actively managed bond funds within a target date series. Both can be appropriate, depending on the goals of the overall strategy. However, there are several issues to consider.

Let’s start with passive. Although passively managed funds generally have lower costs, there are issues with implementation. First, market capitalization-based bond indexes are tilted, by definition, to issuers with greater borrowing needs, which may not represent the best opportunities. Bond indexes can be expensive or very difficult to replicate (due to liquidity issues and transitions in/out of the index). Benchmark selection can greatly influence results. And also note that the risk profile of a benchmark can drift over time, as its duration and credit quality track the decisions of the borrowers represented in it.

Active funds tend to have higher management fees. Moreover, the investment manager may not have incentives that are aligned with the objectives of end investors. For example, an underlying bond fund manager may be incentivized to outpace its peer group, and thus to favor taking credit risk even though this means tolerating large drawdowns in equity bear markets. That objective does not necessarily make the fund an optimal building block in a broader allocation strategy like a target date fund, which relies partly on bonds to cushion equity-market shocks.

Yet given the right incentives, actively managed bond funds have additional tools to help manage risk — they are not obliged to take on the risks of specific credits just because they are included in an index, nor to mechanically track any escalation in the aggregate risk of the index. Moreover, they can seek to exploit mispricing opportunities.

What’s inside the bond allocation

Let’s now turn to a consideration of two unique sub-classes within the fixed income market — inflation-linked and high-yield bonds — within the context of a target date series.

Inflation-linked bonds are designed to provide protection against inflation shocks. This characteristic is particularly important for participants in the transition and early retirement years of the glide path, where the risks of a loss of purchasing power are particularly acute as equity exposure is reduced.

The Target Date Solutions Committee, which oversees American Funds Target Date Retirement Series, has modeled the situations in which TIPS would be useful in a target date strategy. Their benefit is that they respond in a very predictable and mechanical way to higher inflation: The principal of the bond increases in line with the U.S. Consumer Price Index, resulting in higher coupon payments and a higher principal repayment at maturity. In addition, the repayment at maturity is guaranteed not to be lower than the original principal.

However, investors pay an insurance-like “premium” for this predictability: lower expected returns. Indeed, in recent years, real yields on TIPS have been negative. Moreover, TIPS returns still have a return component in common with nominal bonds: Both TIPS and nominal bond returns are affected by changes in real yields. So, it is important to use TIPS thoughtfully, in conjunction with other tools.

Regarding the use of high-yield bonds in a target date glide path, it is important to not think of equities and corporate bonds in isolation. They each give exposure to different parts of a company’s capital structure. The optimal place to invest in the capital structure — equity or debt — depends on market conditions, relative value and the investor’s specific needs.

Owning the debt of a non-investment grade company can often present a better opportunity than owning its equity. Many high-yield issuers are privately held, with no listed equity, so bonds are the only way to invest in them. It is also important to note that the high-yield universe can be quite fluid, with companies graduating to investment-grade status or becoming “falling angels” that drop into high-yield territory.

Within the context of a target date fund, we believe high-yield bonds make sense in the middle of the glide path, where fixed income is expected to contribute a greater share of return as the glide path de-risks by reducing equities.

Flexibility can help participants

Target date funds hit their sweet spot, so to say, during the critical transition phase in the middle of the glide path: It is here where the allocation between equities and fixed income sees the most significant changes as the balance of risks a participant faces evolves. Flexibility is critical here, particularly in a fixed income allocation that is intended to insulate against downside shocks. A series should have the flexibility to adapt to market conditions, managing risk and seeking opportunities by shifting credit quality, duration and geographic exposure as needed.

For passive approaches, where underlying fund managers are more constrained, exposures must be changed from the top down by modifying strategic fund allocations. But this approach lacks the nimbleness of fully active approaches where flexibility is embedded at the underlying fund level. For example, balanced funds in our series allow active managers to shift between bonds and equities (and within sub-asset classes) in pursuit of the best investment opportunities on a day-to-day basis. These changes, in turn, influence the target date fund’s overall asset mix from the bottom up.

Either way, at this stage, it’s critical that the equity and fixed income managers in a target date series are evaluating markets and making decisions in concert, addressing common risks that are manifesting into different asset classes. A target date provider shouldn’t address risks in isolation. It should look at how equities and bonds interact and adjust each accordingly, to pursue better outcomes for participants.

How to help plan sponsors

Consider the various ways fixed income assets can benefit target date investors: While equity diversification remains a critical role for fixed income allocations in a target date series, a more sophisticated approach uses the asset class for other roles as well.

Appreciate the differences in fixed income allocations: While equities sometimes steal the spotlight, be sure to closely examine the differences in the approach and the value added by the fixed income allocations of a target date series. Ensure that the mix of bonds changes with the needs of investors as they move through the life cycle.

TIPS and high yield can play a role: While bonds should seek to dampen equity risk, they can also combat other risks such as inflation shocks, and can provide exposure to unique opportunities.

Exploit flexibility: Flexibility along the various dimensions of fixed income management — including duration, credit quality and geography — can protect and benefit participants transitioning into retirement.

To get a better understanding of our target date series’ fixed income approach, read our white paper.