Dr. Brian Jacobsen, CFA, CFP, is a Senior Investment Strategist with the Wells Fargo Asset Management Multi-Asset Solutions Team.
Fixed-income factors are not as widely discussed as equity factors, but they are equally important in designing a target date portfolio in an attempt to improve participant outcomes. Just as within equities, factors are features of assets that may give better risk/return payoffs over time as they help filter the fundamental macroeconomic forces that drive returns. Within fixed income, these factors can be broadly categorized as being related to interest-rate sensitivity, credit exposure, and inflation sensitivity.
- Interest-rate sensitivity refers to how a security’s price changes when interest rates change. This factor is important to consider for striking a balance between generating income and reducing interest-rate risk.
- Credit exposure from yield-advantaged securities typically generates a positive risk premium over a medium- to longer-term investment horizon, suggesting target-date investments—which are aiming for a long investment horizon—should be biased toward investment-grade, high-yield, and emerging markets debt.
- Inflation sensitivity is important for retirees seeking to maintain their purchasing power when they may not have wage income to compensate for changes in inflation. As a result, target date portfolios will typically increase exposure to this factor over time.
Factor: Interest-rate sensitivity
Sometimes it pays to invest in more interest-rate sensitive assets and sometimes it can hurt. A bond with a longer time to maturity generally experiences a greater change in its price than a short-term security does for a given change in interest rates. Reinvestment risk—the variability in returns from reinvesting in a particular strategy due to changes in interest rates—is also a consideration. To illustrate this concept, we compared the expected return (in this case, the average historical returns) with risk (the historical standard deviation of returns) to assess which would provide the greatest expected return for a given level of risk of three portfolios: short term, medium term, and longer term.
Because target date strategies tend to have long investment horizons, they may benefit from holding longer-maturity portfolios than cash and cash alternatives. If interest rates stay flat or eventually rise, however, keeping maturities closer to the intermediate range of the yield curve may be prudent because there is little historical evidence of a benefit to investing in extremely long-term securities relative to intermediate-term securities. Investing in intermediate-term securities, therefore, helps lower the risk of incurring a negative risk premium from reinvestment rate risk that is common with T-bills, but it also attempts to avoid excessive interest-rate risk associated with longer-dated fixed income.
Factor: Credit exposure
Another common factor in fixed-income investing is credit exposure because investing in securities with an element of credit risk has historically generated positive risk premiums over time. For example, U.S. Treasuries are assumed to have minimal default risk and therefore, as a less risky asset, have no credit premium. At the other end of the spectrum, high-yield bonds have greater credit risk and therefore command a significant yield advantage over Treasuries, known as the credit spread. The credit risk premium depends on the initial level of the credit spread and the economic environment that prevails during the holding period. Historical data shows that the credit risk premium tends to decline as the holding period lengthens but its standard deviation begins to stabilize after a fairly short holding period, providing a sense of what a reasonable investment horizon may be for benefiting from credit exposure.
A second consequence of the typically longer-term investment horizon of target date investors is that their time horizon allows them to be compensated for credit risk and therefore credit exposure might be an important source of return. Investment-grade corporate bonds usually provide income beyond what Treasury securities can, often with less duration risk. High-yield bonds usually provide additional income with more diversification benefits as they are even less correlated with Treasuries than investment-grade corporates.
Factor: Inflation sensitivity
Different securities behave differently depending on the inflation environment, and this is an especially important consideration for target-date investors. Those who are working can typically expect raises in their paychecks to compensate for increases in inflation. Since 1983, according to the Federal Reserve Bank of Atlanta’s Wage Growth Tracker, which measures wage growth of those continuously employed, wages grew—on average—1.3% faster than inflation as measured by year-over-year changes in the Consumer Price Index. Only 11% of the time did the average wages of those continuously employed fail to keep up with inflation. As a result, getting exposure to investments with positive inflation sensitivity may be an important consideration for those approaching retirement and those in retirement.
Many fixed-income securities, especially shorter-term corporate debt, have attractive inflation sensitivity where the returns can more than compensate for inflation. However, there are two additional considerations for target date investors. First the sub-asset classes performed differently depending on the point in the business cycle due to credit risk. Second, because many fixed-income investments are highly correlated with each other, it may be important to consider which asset classes have low correlations to other assets in the portfolio in an attempt to diversify the set of inflation-sensitive assets.
Inflation-sensitive sectors most notably include TIPS, which can specifically target mitigating inflation risk. Another inflation-sensitive sector—emerging markets bonds—not only have a historical record of beating inflation and generating income, they also have additional diversification properties U.S. fixed income instruments do not. By having returns that are often driven by macroeconomic forces unique to emerging markets, they attempt to provide macroeconomic diversification for an otherwise all U.S.-based portfolio. However, they also have significant credit risk, meaning that they should not just be tacked onto a portfolio that already has credit risk exposure.
Putting the factors together
Each factor of a fixed-income portfolio—so interest-rate sensitivity, credit exposure, and inflation sensitivity—may play an important role in constructing a dynamic fixed-income portfolio for target date investing. These might help improve retiree outcomes because they seek to limit interest-rate and reinvestment risk, benefit from credit exposure to yield-advantaged sectors, and maintain purchasing power by allocating to sectors whose returns keep pace with or outpace inflation.
|Fixed income sub-asset classes||Primary role of sub-asset class in portfolio||Factor used|
|U.S. intermediate-term bonds||Mitigate interest-rate risk and reinvestment risk||Interest-rate sensitivity|
|U.S. investment-grade corporate bonds||Mitigate volatility, provides income, additional diversification||Credit exposure|
|High-yield bonds||Mitigate longevity risk, additional diversification||Credit exposure|
|TIPS||Mitigates inflation risk||Inflation sensitivity|
|Emerging markets bonds||Mitigate longevity risk, additional diversification||Inflation sensitivity and credit exposure|
The target date represents the year in which investors may likely begin withdrawing assets. The investments gradually seek to reduce market risk as the target date approaches and after it arrives by decreasing equity exposure and increasing fixed-income exposure. The principal value is not guaranteed at any time, including at the target date.
The strategies invest in alternative investments, such as short sales, which are speculative and entail a high degree of risk. The strategies invest using alternative investment strategies, such as equity hedged, event driven, global macro, and relative value, which are speculative and entail a high degree of risk. Alternative investments, such as commodities and merger arbitrage strategies, are speculative and entail a high degree of risk. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the strategies. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest-rate changes and their impact on the strategies and its share price can be sudden and unpredictable. High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities. The use of derivatives may reduce returns and/or increase volatility. Securities issued by U.S. government agencies or government-sponsored entities may not be guaranteed by the U.S. Treasury. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). The strategies are exposed to foreign investment risk, mortgage- and asset-backed securities risk, new security risk, regulatory risk, and smaller-company investment risk. Consult the strategies prospectus or offering document for additional information on these and other risks.