The bond market is far larger today than two decades ago — and has risen to over $100 trillion, as shown in Exhibit 1. The United States represents less than 40% of the global fixed income market. Most of the growth has occurred outside of the United States, which means there are more global opportunities to add fixed income to a portfolio and help improve diversification and income potential. But there is also greater risk — global fixed income investing may expose investors to currency risk, greater volatility and potentially greater levels of credit risk. This is why it is important for plan professionals to look under the hood of any TDF — they should know where their plan participants have exposure. It is also crucial to understand the investment research resources and commitment a TDF manager has to non-US fixed income sectors — because investing in these areas requires specific skills and expertise.
Exhibit 2 shows that TDFs with allocations solely to the US Aggregate fixed income universe have missed potential return and diversification opportunities over the last decade. High yield and emerging market bonds, for example, have performed well over the last 3-, 5- and 10-year periods. These two sectors are not part of the US Aggregate universe, which means they may not be captured in a TDF primarily focused on the US Aggregate, which has a high concentration of lower-return and interest rate–sensitive sectors of the market such as US Treasury and agency bonds. High yield and emerging market bonds are generally riskier than the US Aggregate, however, which should be considered as part of any allocation decision.
Retirement savers often misunderstand “duration” risk, or the sensitivity of bond prices to changes in interest rates. When rates rise, bond prices tend to fall. But this isn’t true to the same degree for all bond sectors. US Treasuries, for example, tend to be highly correlated with interest rates and are often more volatile than other sectors during periods of rising rates. Exhibit 3 shows the correlation of different bond sector returns to the Bloomberg Barclays US 7-10 Year Treasury Bond Index, which can serve as a general proxy for US rates. A correlation of 1 means two asset prices moved in lockstep, while a correlation of -1 indicates assets moved in opposite directions. Looking back to 1994, US government bonds and mortgage backed securities have had high correlations with interest rates, while investment grade credit and global sovereign bond returns have had moderate correlations. Emerging markets debt (EMD) and high-yield corporate bonds, on the other hand, have experienced low correlations with interest rates during this period. This shows another reason why a diversified fixed income portfolio should consider including exposure to global bonds, high-yield and non-traditional bond sectors — they may help moderate the effects of volatility during periods of rising interest rates.
While the fixed income marketplace has evolved over the years, investors still largely have the same goals within their bond portfolios — stability, income and diversification. There is also plenty of risk to consider, including the risk in a passive or index approach that is closely aligned with the traditional US Aggregate universe. Plan sponsors should always look under the hood at the fixed income allocation of a TDF to determine whether it is adequately diversified and how it may fare in a rising rate environment or during periods of higher inflation.
1Target date funds allow savers to choose the time horizon that best matches their specific financial goals consistent with the approximate retirement year in the fund’s name. These funds automatically rebalance a portfolio’s asset mix over time, for example, shifting from an aggressive to a conservative profile as participants move closer to their retirement date. The principal value of the fund options are not guaranteed at any time; the funds’ objectives and investment strategies change from one target date to another. A glide path is the fund’s predetermined plan for changing the fund’s mix of investments (“asset allocation”) over time, from being more heavily weighted toward stocks to more heavily weighted toward bonds.
Joseph C. Flaherty, Jr.
Chief Investment Risk Officer
Natalie I. Shapiro, Ph.D.
Derek W. Beane, CFA
Director, Investment Products
Keep in mind that all investments carry a certain amount of risk including the possible loss of the principal amount invested.
Diversification does not guarantee a profit or protect against a loss.
The views expressed are those of MFS and are subject to change at any time. These views are provided for informational and educational purposes only and may not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. The investments you choose should correspond to your financial needs, goals, and risk tolerance. Please consult with your investment professional before making any investment or financial decisions or purchasing any financial, securities or investment related service or product, including any investment product or service described in these materials.
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