Are You Taking Unknown Risks in Passive Bond Exposures?

A key decision in selecting a target date series is whether the underlying funds are actively or passively managed. Although significant attention has been given to passive equity strategies, plan sponsors and consultants should also carefully consider the use of passive bond funds, as they present special considerations. In evaluating passive bond funds in a series, it’s important to answer several questions.

How Does the Series Seek to Replicate Bond Indexes?

Liquidity and cost concerns can prevent passive bond funds from owning all issues within an index. Therefore, many bond index fund providers use sampling methodologies to seek to replicate the index’s characteristics. These sampling techniques can introduce a degree of tracking error not seen with many equity index funds.

What Are the Rules of the Index?

The constituents of bond indexes can change more frequently and by greater degrees than equity indexes. Moreover, most bond indexes are weighted based on the size of issuance. In the corporate space, this means that index funds are tilted toward the most indebted firms. However, the biggest borrowers aren’t necessarily the best credits. Higher indebtedness can weigh on balance sheets, potentially contributing to a credit rating downgrade.

What Are the Index’s Exposures and How Have They Changed?

The sectors and characteristics of bond indexes can drift over time. For example, the portion of the Barclays U.S. Aggregate Index devoted to U.S. Treasuries rose from 25.2% at the end of 2005 to 36.4% on December 31, 2015. Over the same time frame, the index’s duration — a measure of the increasing price sensitivity to interest rate changes over time — rose from 4.57 years to 5.68 years — a 24% increase. In contrast, actively managed funds can manage duration and sector exposure. Duration management can be especially important in rising rate environments.

Which Asset Classes Do the Passive Bond Funds Include?

Different indexes track different types of bonds. For example, the Barclays U.S. Aggregate Index contains no high-yield bonds, municipal bonds, emerging markets bonds or U.S. Treasury Inflation Protected Securities. Unless a passive target date series tracks bond indexes with those investments, those asset classes won’t be offered to participants. Target date series may have separate, dedicated exposures to high yield and TIPS, but generally will not be able to invest opportunistically in those sectors.

Conclusion

Since bond index funds tend to be more complicated than equity index vehicles, investors should pay special attention to how passive fixed-income investments are managed. They also should consider active bond funds, which can seek to provide income and appreciation while managing risk.