Active fixed income within target-date strategies

In the past few years, the world has experienced significant economic events, including a historic decline and subsequent recovery in global economic growth, a global inflation shock, significant central bank tightening, and increasing geopolitical tensions. These occurrences have resulted in notable shifts in capital markets, including an inflection in the fixed-income market with bond yields rising above their long-standing downward trend. While time will tell how profound and persistent these shifts prove to be, we believe that active management within fixed income can be critical to delivering on participants’ retirement planning objectives within diversified target-date options.

The potential to improve target-date performance through active fixed-income management

Over the past several decades, the traditional fixed-income index—the Bloomberg U.S. Aggregate Bond Index (Agg), which tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets—generated mid-single-digit returns that outpaced inflation with relatively low volatility. However, as governments increasingly grapple with large budget deficits, changing demographics, geopolitical risks, and deglobalization, they’re issuing more bonds to help meet pressing needs. The result may likely result in more challenging and volatile fixed-income markets going forward, which is one of the contributing factors supporting our view that active fixed-income management is integral to enhancing the performance potential of a target-date strategy.

Crucial to a target-date strategy is the ability of active fixed-income managers to tap the depths of the bond market to provide greater potential opportunity than what can typically be gained from passive fixed-income implementation alone.

For instance, over the past 20 years, a diversified strategic fixed-income mix that incorporated asset classes aligned with retirement readiness themes outperformed the Agg by over 100 basis points per year while also achieving a better Sharpe ratio, which measures excess returns generated per unit of risk within an investment.

Fixed-income indexes are weighted toward issuers that have issued the most debt—a limitation that underpins our conviction in active management. The Agg, for example, holds over 40% U.S. Treasuries and 25% agency mortgage-backed securities, resulting in a high concentration in U.S. sovereign debt rather than diversified fixed-income exposure. Similarly, within corporate debt, high issuance may be a sign of overindebted issuers, a key signal of higher risk. Active management helps to manage these risks through security selection and managing exposure to differing sectors based on the targeted risk and return profile of a portfolio. Important to note is that active management generally comes with higher management fees and costs. This is important for plan sponsors and financial professionals to consider. Lowering total portfolio costs is an important objective; it’s also one of the reasons we believe in an approach that combines passive and active investment implementation. It makes sense to lower costs with passive approaches for broad market exposure, such as within equities. By doing so, active management can be used where it has the potential to add significant value, such as within fixed-income security selection, while aiming to lower overall portfolio costs for participants.

Active fixed income helps to improve a manager’s maneuverability in good as well as challenging times

In addition to mitigating concentration risk and higher risk among issuers, active fixed-income management provides the ability to maneuver duration—trading from a longer to shorter duration profile—which can be a particularly valuable lever leading into, and in the early years of, retirement.

Similarly, the past few years have seen a significant rerating of fixed-income spread sectors. Spread tightening has occurred alongside reduced issuance as well as with the emergence of private credit as a financing option for issuers with speculative credit ratings. However, there’s risk that lies in spread widening that, we believe, requires active management. Based on historical precedence, when spreads begin to widen, they often move quickly, leaving little time to seek refuge. Active fixed-income managers who can nimbly navigate credit markets tend to bring a valuable skill set to a target-date strategy.

After a volatile past few years for fixed income, it’s impossible to predict the precise outlook for bond markets as monetary policy starts easing. Where there’s increased risk, there’s also typically increased opportunity, but it may not be effectively accessible through an index-based approach. Active fixed-income management represents the potential for both a broader tool kit for diversification and additional distinct sources of return that aim to enhance the durability and outcomes of a target-date strategy.

Financial professionals looking for more information on diversification and active fixed income management within target-date strategies can access our white paper.