Janus Henderson’s Portfolio Construction and Strategy (PCS) conducted an assessment of the key challenges of fixed income in retirement plan lineups. Here, Senior Portfolio Strategist Damien Comeaux explains how certain fixed income categories can expose participants to unnecessary risk despite the diversification benefits they might provide, and why additional due diligence is required when evaluating these options.

Janus Henderson’s Portfolio Construction and Strategy (PCS) team developed a diagnostic report specific to retirement plans that provides a comprehensive analysis on the risk and reward of fixed income investments in plan lineups. In our conversations reviewing this diagnostic report with DC-focused financial professionals, we identified four areas we believe are the most crucial to consider in order to avoid the complications of implicit and unintended risk.

We cover each of those challenges in detail in our four-part blog series. Here, we explain how certain fixed income categories can expose participants to unnecessary risk despite the diversification benefits they might provide, and why additional due diligence is required when evaluating these options.

Categories like multi-sector bond and world bond are clear contenders for the open slot in plan menus that is created by eliminating either the Core or Core-Plus option. These categories offer opportunities for diversification, in which plan participants can avoid the “too much duration” with “too little yield” dilemma of the more traditional, government-centric fixed income asset classes. But alas, they come with their own challenges.

As lineups look to enhance diversification, it’s important to acknowledge that diversification for the sake of diversification doesn’t always work out as intended. While diversifying the duration/yield trade-off, strategies in these categories can sometimes end up being more aggressive than anticipated by delivering significantly more volatility than expected. This can expose participants to unnecessary risk despite the diversification benefits. Therefore it’s important that DC-focused financial professionals have a firm grasp on the specific risks these new categories may introduce.

One of the most common places we’ve seen this misunderstanding is in the world bond space, which is made up of two sub-categories: World Bond and World Bond – USD Hedged. While a basic investment in either of these categories may help provide additional diversification, it could also very easily expose a participant to unwanted currency risk relative to the USD Hedged World Bond category. Examine the 10-year analysis shown below:

Source: Morningstar, as of 6/30/21.

 

Note the differences in 10-year outcomes when currency risk is part of the equation compared to when that risk is hedged out to the U.S. dollar. The most striking example of the negative impact participants could experience is in the 10-year maximum drawdown, in which the unhedged category underperforms its hedged counterparts by over 300 basis points.

While the example in the chart above focuses on just the two world bond categories, the concept illustrated certainly applies to other diversifying fixed income options outside of those traditional, government-focused fixed income securities.

It is incumbent on plan lineups to select diversifying elements for the fixed income sleeve but also to understand the level of risk – as well as excess risk – that these options may introduce in participants’ allocations. As a risk-based asset allocation team, we are not as concerned with the returns as we are the risk differential, and unhedged currency risk is exactly that: risk. As such, we believe participants may be better served by having this uncertainty excluded from their fixed income allocation.

The chart below provides a five-year look back at the Multi-Sector Bond category in three areas. It is clear there is significant dispersion among category constituents in both traditional risk and return attributes, standard deviation and annualized return. But variance among the category becomes even more apparent in risk-off environments, such as 2018 (a discrete time period) when the S&P 500^® Index lost 4.4%.¹ 2018 is likely a time when participants expected their fixed income to act like fixed income even though some managers clearly did not.

Returns and Standard Deviation – Multisector Bond Category (7/1/16 – 6/30/21)

Source: Morningstar as of 6/30/21.

 

Our goal in sharing these insights is to ignite conversations that help construct the best lineup possible for plan participants. We hope that by considering some of the factors discussed in this series and adding them to your due diligence arsenal, you are able to select options for your plan menu that better suit participants’ needs.

 

¹Source: S&P 500 Index

Core Bond portfolios invest primarily in investment-grade U.S. fixed income issues and hold less than 5% in below-investment-grade exposures.

Core Plus portfolios invest primarily in investment-grade U.S. fixed income issues, but generally have greater flexibility than core offerings to hold non-core sectors and up to 35% in below-investment-grade exposures.

Multisector Bond portfolios seek income by diversifying their assets among several fixed-income sectors and typically hold 35% to 65% of assets in below-investment-grade exposures.

World Bond portfolios typically invest 40% or more of their assets in fixed-income instruments issued outside of the U.S and may maintain significant allocations to non-U.S. dollar currencies.

World Bond-USD Hedged portfolios typically invest 40% or more of their assets in fixed-income instruments issued outside of the U.S. and hedge non-U.S. dollar currency exposure back to the U.S. dollar.