Fixed income is generally considered a risk-reducing or diversifying asset class for institutional investors. Depending on the objectives of their asset pool, its specific role, implementation, and utilization varies among institutional investors.
What role does fixed income typically play in DB plan portfolios?
Corporate defined benefit pension plans, which are concerned about the impact of their pension plan on their balance sheet, tend to have a specific and focused use of fixed income. They often employ customized fixed income portfolios to hedge against the interest rate risk associated with their pension plan liabilities. The fixed income portfolio is often viewed separately from the return-seeking portion of the portfolio.
How the role of fixed income differs for non-profit investors
On the other hand, non-profit investors, ranging from hospitals and healthcare systems to endowments and foundations, are more likely to consider fixed income as an integral part of their overall portfolio strategy. These investors typically have total return objectives-whether tied to outperforming their organization’s cost of capital or broader inflation metrics-for the portfolio. This approach leads to a comprehensive assessment of the portfolio to determine the most efficient way to achieve the required portfolio return.
Consequently, for these investors, the fixed income portfolio is seen as a component of return generation to meet the overall portfolio objective while maintaining as low of a risk profile as possible. In this context, it’s not the absolute risk within the fixed income portfolio that matters, but both its ability to generate returns to reduce the reliance on equities, and the diversification it provides relative to the growth assets. This allows different types of fixed income to find places in non-profit investment portfolios while serving different roles.
The return side of the equation
High-yield debt is riskier than investment-grade credit due to the increased potential for defaults and widening spreads during stressful market conditions. However, it can play a crucial role in the overall portfolio due to its return-generating capacity, which can reduce the reliance on equities.
Similarly, investment-grade credit, although introducing more portfolio risk and volatility than Treasuries, offers higher returns and allows for a greater allocation to investment-grade fixed income within the overall portfolio compared to a pure allocation to Treasuries. It is the focus of the impact on total portfolio return that leads to high yield and investment-grade credit having important roles in managing risk within the total portfolio for non-profit investors, even though they are riskier investments than Treasuries.
The risk side of the equation
From an absolute risk perspective, the lowest risk fixed income asset classes are cash and short-duration Treasuries. If an investor seeks a highly stable fixed income portfolio with minimal volatility, they should opt for a short-duration Treasury portfolio. Even though Treasury duration has standalone volatility, it typically provides diversification benefits to the overall portfolio during stressed market environments.
Although notably not the case in 2022, in most equity market selloffs, interest rates fall, resulting in gains for Treasury portfolios. The higher the interest-rate sensitivity of the portfolio1, the larger the gains when interest rates decline. This underscores the importance of ensuring that the fixed income portfolio has meaningful interest-rate sensitivity for absolute portfolio risk management, as it contributes more to the reduction of overall portfolio risk compared to investing in a fixed income portfolio with low duration and standalone risk.
The typical desire for nominal bonds with intermediate to long duration exposure in a non-profit portfolio assumes that the investor is focusing on minimizing the risk of absolute portfolio drawdowns, rather than the risk relative to inflation or as a liquidity reserve. As exhibited in 2022, nominal bond duration does not provide portfolio protection in periods of unexpected increases in inflation. For an institutional investor that is prioritizing sensitivity to unexpected changes in inflation, along with other portfolio changes, the duration of the nominal fixed income investments should be shortened and a portion of the nominal bond portfolio should be re-allocated to inflation-linked bonds/TIPS.
Should non-profit investors consider making changes to their portfolios amid today’s high-yield environment?
Given the typical role of fixed income in most portfolios, a common question is if it should be adapted in the current market environment. After all, yields are higher and inflation concerns are abating. Should this lead to large changes in portfolio construction for investors?
The answer is likely dependent on how the investor has constructed its fixed income portfolio. For investors that shortened the duration of their fixed income portfolios prior to 2022 due to concerns about rising interest rates and inflation concerns, that positioning has been rewarded and the time has come to bring the duration back up to strategy.
However, for an investor that is already allocated in line with its strategic preferences, the answer is more nuanced. Current market instability and uncertainty is leading us to believe that now is not the time to take large tilts from strategic positions. Although inflation risks have decreased since 2022, it still remains to be seen if the U.S. Federal Reserve (Fed) will be able to meet its policy target of 2% inflation. While history tells us they should be able to do so, the uncertainty around productivity, deglobalization and other global trends can complicate matters. This increases uncertainty on inflation and therefore interest rate forecasts.
In the current market environment dominated by high yields and uncertain recession risks, the preferred positioning is to increase interest rate sensitivity. The most attractive yields are at the shorter end of the yield curve, so for an investor with the ability to lever their portfolio, we believe they could use derivatives to significantly increase exposure to 2-year yields. However, for most investors that are not using leverage to manage their portfolios, any preference to increase the interest-rate sensitivity will naturally mean investing in longer-duration bonds. Nevertheless, although we see advantages to tilting the portfolio to have higher interest rate sensitivity, we believe that any long duration position should be moderated due to a desire to control tracking error in an uncertain market environment.
What role can TIPS play in a portfolio?
Despite the generally falling inflation concerns, we also see attractiveness in accessing interest rate duration through TIPS. The 5-year breakeven inflation rate currently sits at 2.2%2, while the CPI (consumer price index) remains meaningfully above 3%. Although concerns about skyrocketing inflation have diminished and no longer dominate discussions, as discussed, we believe that inflationary tail risk remains, from which TIPS can provide some protection.
This, combined with the relative attractiveness priced into the differential between nominal and inflation-linked securities (i.e., breakeven inflation of 2.3% while inflation is above 3%) implies that in a scenario where inflation remains low but above the Fed’s target, TIPS can provide a return benefit relative to nominal bonds. However, in the event of a market selloff, TIPS would provide less total portfolio protection than nominal Treasuries, so the return attractiveness of TIPS must be weighed against an investor’s desire to maintain total portfolio protection in a stressed event.
The bottom line
While the recommended positioning will vary based on specific time horizons and objectives, we believe that for all investors, now is not the time to make significant deviations from strategy, unless specific client circumstances lead to that being an appropriate choice. For non-profit investors, we think it’s especially important that the fixed income portfolio is managed within the context of the total portfolio objectives.
Ultimately, while we view fixed income as increasingly attractive in the current environment, we would moderate any tilts based on this due to the significant uncertainty on how investment returns may unfold over the next few years.
1 Typically for clients that do not use leverage at the total portfolio level higher interest rate sensitivity is generated by investing in longer-duration bonds, however it could also be possible to lever exposure to bonds of any duration to increase interest rate sensitivity of the portfolio.
2 FRED 5-Year Breakeven Inflation Rate as of October 11, 2023
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