In this paper, we discuss our approach and philosophy to fixed income in American Funds Target Date Retirement Series®, which we would describe as prudent and measured in broad terms.
In the decade or so that target date funds have become a mainstream default option for retirement plans, a lot of attention has been paid to equity’s role in the glide path. Bonds play an equally important role near and during retirement.
Our prudent and measured approach to bonds in the glide path is consistent with our overall philosophy underpinning the series. In our view, as target date funds become the primary vehicle for retirement savings in defined contribution plans, they should provide adequate downside protection while also focusing on capital appreciation. Fixed income obviously plays a critical role in capital preservation.
Target date providers spend considerable resources on portfolio construction. Passive providers tend to work with broad asset classes of equities and bonds. However, an important aspect of portfolio construction that tends to get overlooked is the types of equities and bonds that are used in the series, and how they must work together. For example, early in the accumulation phase in our series, when the emphasis is on growth stocks that traditionally provide the greatest capital appreciation, bonds’ primary role is to dampen some of the equity volatility. U.S. government bonds — which have historically shown low-to-negative correlation to equities — are a cost-effective option for this purpose.
In the transition phase, growth of income and lowering drawdown risk become more important. However, that burden should not fall entirely on bonds. Dividend-paying and dividend-growing equities have provided income with historically lower volatility than growth-oriented stocks. By reducing the equity exposure in the series and shifting it toward dividend payers, equity volatility should be lowered, allowing us to expand the sources of income to include higher yielding bonds, such as U.S. high yield and non-U.S. fixed income, that should exhibit slightly greater volatility.
Multi-Asset Funds Can “Tilt” a Series’ Exposures Based on Valuations and Other Factors
Fixed income allocations based on historical asset mix of underlying funds over series lifetime
Source: Capital Group. As of December 31, 2015. Average and ranges of exposure were calculated using the historical quarterly asset mix of each underlying fund since the inception of American Funds Target Date Retirement Series, based on the glide path as it existed on December 31, 2015.
We treat high yield as falling somewhere between equities and bonds — providing both income and total return potential. U.S. high yield has exhibited a high correlation of 0.6 to stocks over the past 20 years. Over long horizons, we believe that dividend-paying stocks offer advantages over high yield, including greater appreciation potential, better liquidity, higher market capitalization and broader diversification. However, as income becomes more important near retirement, it is beneficial to diversify the sources of income through high-yield and non-U.S. bonds.
In addition, non-U.S. bonds provide diversification from U.S. core fixed income. Non-U.S. bonds are responsive to economies that can be at different stages of the monetary and business cycle than the U.S. Emerging markets debt and high-yield bonds tend to have shorter duration, which helps our series dampen interest rate risk.
Specific sub-asset classes of fixed income can play a specific role. Treasury Inflation-Protected Securities (TIPS) address the risk of inflation shocks in the later stages of the glide path. In the early stages, when the investment horizon is long, equity returns and rising salaries provide that hedge. Nearing and during retirement, these solutions may not be as effective: equities have too much short-term market risk, and salary contributions have ceased playing a role.
Additionally, TIPS adjust to inflation quickly, providing a more precise hedge against inflation. The series gains TIPS exposure through a dedicated TIPS fund and through broader bond funds that have the flexibility to invest in TIPS; such flexibility is helpful given that TIPS valuations can vary significantly depending on market conditions.
Bonds and Equities Should Work Together
Asset class exposures in American Funds Target Date Retirement Series (percentage of fund allocation)
As of June 30, 2016. Source: Capital Group. Lower yielding equities are those in underlying funds with SEC yields ranging from 0% to 1.5%, as of June 30, 2016. Medium-yielding equities are those in underlying funds with SEC yields between 1.5% and 3%. Higher yielding equities are those in underlying funds with SEC yields above 3%. Portfolio managers of certain underlying funds have the discretion to invest among multiple asset classes, such as stocks and bonds, or U.S. and non-U.S. equities; therefore, the asset class mix of the target date series will change over time, depending on managers’ future investment decisions.
An important aspect of our approach is that we work to ensure that bond funds remain true to their stated objectives, which strongly influence a fund’s risk-return profile. A bond fund’s risk-return profile is especially important in retirement, when participants seek to generate income and dampen equity market volatility.
In the distribution phase, we believe bonds should be managed conservatively, focusing primarily on U.S. short-term or intermediate-term high-quality securities. These funds should adhere to their stated objectives and not venture too far out on the risk spectrum to generate extra yield or total return potential.
For example, our short-term bond fund — which is used heavily in distribution for income and preservation — holds government and corporate bonds at the upper end of the investment-grade credit-quality spectrum.
In contrast, there are some short-duration bond funds in the marketplace that provide a yield above the 30-year Treasury. It is difficult to see how a shortduration fund can achieve yield above long-duration bonds without taking on undue credit risk. Similarly, it surprises us when a global bond fund has 40% of its assets invested in emerging markets.
Bond Funds Within the Same Category Can Vary in Credit Quality
Credit quality (as % of assets)
Data as of March 31, 2016. Source: Morningstar®. Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor’s, Moody’s and/or Fitch, as an indication of an issuer’s creditworthiness. If agency ratings differ, the security will be considered to have received the highest of those ratings, consistent with the fund’s investment policies. Securities in the Not Rated category have not been rated by a rating agency; however, the investment adviser performs its own credit analysis and assigns comparable ratings that are used for compliance with fund investment policies.
Given these variations, underlying bond funds belonging to the same Morningstar category can have meaningfully different asset allocations and therefore different risk-return profiles. For instance, Short-Term Bond Fund of America (STBF) from American Funds had significantly more assets in the two top credit tiers (AAA and AA) than its category average. It also had greater government exposure and less credit exposure than the Morningstar average.
Given STBF’s lower credit exposure, it’s not surprising that the fund had a significantly lower correlation to the Standard & Poor’s 500 Index than its category average over the last three years. Similar stark variations can be seen even among U.S. core funds. Our series’ U.S. core bond fund, The Bond Fund of America (BFA), likewise had more assets in the top two credit tiers, less credit exposure, and a lower correlation to equities than its category average.
In assessing underlying bond funds used during retirement, it is important to consider a fund’s credit quality, correlation to equity and its sector exposure. The relevance of excess return as an evaluation metric can vary depending on the differing role bonds play at each stage of the glide path. During retirement, a lower correlation to equity may be a more relevant metric than returns that exceed peers or benchmarks.
Rather than evaluating bond funds in isolation, we believe it is more important to consider each bond fund’s role in the glide path and how the fund interacts with other types of bonds and equities at each part of the saving cycle.
Bond Funds Within the Same Category Can Have Very Different Equity Correlations
Three-year correlation to S&P 500 Index, as of June 30, 2016
Source: Capital Group, based on Morningstar data. Results based on Class R-6 shares.
Most of the fixed income in our series comes from dedicated bond funds. A smaller but significant amount comes from flexible multi-asset funds. Broadly speaking, these multi-asset funds are geared toward objectives like capital preservation, current income, and growth of income. By virtue of these investment goals, the funds’ equity risk profile is generally more conservative than a purely growth-oriented strategy. Hence, these funds play a greater role near and during retirement, when income and preservation are important.
The multi-asset framework allows for equities and bonds to work together toward a single investment objective. Managers seek to achieve specific investment goals, such as high current yield or a growth-of-income target, through bottom-up security selection against the backdrop of a broader top-down macroeconomic framework. This approach brings in the important filters of valuation and fundamental analysis. For example, if valuations of high-dividend-paying stocks are stretched or if the companies are not attractive on a fundamental basis, managers may prefer owning bonds for yield, and vice versa. If bond yields are low and stocks are not attractive, it may signal something about risk and the economic environment, and managers may end up raising cash in portfolios. Another aspect of this valuation-based approach is that the resulting shifts in asset allocation between stocks and bonds, and among sectors within those asset classes, tend to be gradual and measured in size and pace.
The fixed income investments tend to be mostly investment grade, but also include high yield depending on valuations and on the fund’s charter. Within investment-grade fixed income, managers will alter weightings among various sectors based on valuations and their expectations for the term structure of interest rates.
We find the tactical flexibility that these funds provide to be invaluable. It provides a degree of agility on the margins without having to make frequent changes to the glide path. In addition, recent research has shown that valuation-based asset allocation can provide benefits over topdown static allocations.*
Multi-Asset Funds Provide Important Tactical Flexibility
Multi-asset underlying funds in American Funds Target Date Retirement Series
Data as of June 30, 2016. Source: Capital Group. Fixed income exposure based on monthly data; largest year-over-year change based on rolling one-year periods (in absolute terms). Standard deviation based on monthly returns (Class R-6 shares). American Funds Global Balanced Fund began operations on February 1, 2011; therefore, the fund does not have a 10-year history.
Active management can add substantial value to fixed income portfolios through duration and yield curve management and credit selection. Active funds can adjust duration in response to a changing interest rate outlook; in contrast, passive bond funds effectively track the index’s duration, creating potential challenges with “index drift.” Case in point: Over the past 10 years, the duration of the Barclays U.S. Aggregate Index has drifted upward, driven by a flood of long-dated issuance from the U.S. Treasury, as well as firms seeking to lock in low interest rates.
Additionally, active managers can seek to adjust their sector exposure. An index’s sector exposure is strongly influenced by the size of issuance in the marketplace; therefore, changing issuance patterns can cause an index’s sector exposure to drift, potentially creating unintended risks. For instance, the amount of U.S. Treasuries represented in the Barclays U.S. Aggregate Index has surged due to U.S. government borrowing post-credit crisis. In contrast, an actively managed fund can, to a certain extent, adjust sector exposure based on an informed assessment of valuation and risk-return outlooks.
In addition, using passive bond strategies can potentially increase credit risk in the portfolio. Since bond indexes are market-weighted, they are tilted to the largest and most frequent borrowers. Consequently, passive investors can have greater exposure to more heavily indebted companies, which may not be the best credit investments. In contrast, active investment-grade bond funds can seek to manage credit risk by avoiding issuers at risk of downgrade, or targeting issues that are likely to be upgraded.
Liquidity and cost concerns prevent passive bond funds from owning all issues within an index. Therefore, many index fund providers use sampling methodologies to seek to replicate the index’s characteristics. These sampling techniques can introduce a degree of uncertainty, especially in the event of a liquidity crisis.
Additionally, different indexes encompass different types of bonds. For example, the Barclays U.S. Aggregate Index contains no high-yield bonds, emerging markets bonds or U.S. Treasury Inflation Protected Securities. Unless a passive target date series tracks indexes with those investments, those asset classes won’t be offered to participants. Passive 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.
Active Strategies Can Seek to Manage Risk by Counteracting “Index Drift”
Duration and U.S. Treasury exposure of Barclays U.S. Aggregate Index
Source: Barclays. As of June 30, 2016. Duration, generally expressed in years, is the estimated price sensitivity of a bond to a given change in interest rates. Typically, prices of bonds with longer durations are more sensitive to interest rate changes. Option-adjusted duration accounts for the impact of interest rate changes on bonds with embedded options, such as call or put provisions.
*Kitces, Michael, and Wade D. Pfau, 2015. “Retirement Risk, Rising Equity Glidepaths, and Valuation-Based Asset Allocation.” Journal of Financial Planning 28 (3): 38-48. The authors conclude that “retirement outcomes can be improved with a dynamic asset allocation strategy that adjusts the stock allocation in response to market valuations.”
The glide path’s underlying funds, as well as the fund allocation percentages, are subject to the Portfolio Oversight Committee’s discretion and will evolve over time. Underlying funds may be added or removed during the year. Portfolio managers of certain underlying funds have the discretion to invest among multiple asset classes, such as stocks and bonds, or U.S. and non-U.S. equities; therefore, the asset class mix of the target date series will change over time, depending on managers’ future investment decisions.
Higher yielding, higher risk bonds can fluctuate in price more than investment-grade bonds, so investors should maintain a long-term perspective.
Barclays U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market. The index is unmanaged and, therefore, has no expenses. Investors cannot invest directly in an index.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
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