The turbulent conditions that made 2013 the most challenging year for fixed income investors for more than a decade are set to continue.As the Fed tapers its quantitative easing programme, bond market participants are seeking ways to avoid the huge losses that a rise in interest rates could inflict on their portfolios. And while the search for potential solutions intensifies, one thing is becoming clear: sticking to old-fashioned, tried-and-trusted approaches will no longer work.
The reason for the relatively poor recent performance of traditional fixed income portfolios is clear enough: for years, traditional core bond strategies have tended to track or exceed a market index, such as the Barclays Global Aggregate Index, which has become dominated by interest rate-sensitive government and government-related issues. Investing in this way worked well during the 30-year bull market in interest rates, but last year the Barclays Aggregate Index lost 2.1% after posting an average annual return of 8.9% between 1981 and 2012 – its first negative return since 1999.
Add to this the fact that different regions are adopting markedly different monetary and fiscal policies, resulting in a divergence in fixed income performance by region and asset class, and the implications become clear: simply put, it means that fixed income investors will need to exercise opportunism and flexibility as markets adjust rapidly to changes in economic prospects, monetary policy and secular dynamics that promise to play out differently in various parts of the world.
DC investors have traditionally focused on an investment strategy that seeks to generate strong returns to maximise the value of their asset ‘pot’ at retirement, which is used to purchase an annuity, providing an income for life in retirement.
Over time, however, DC investors have recognised the importance of an investment strategy (and default investment choice to members) that seeks to maximise investment returns for a specified level of risk. This typically involves diversification across a range of global equity allocations, real estate and other multi-asset funds.
One significant risk of annuity purchase at retirement is that extreme market movements in the years leading up to an individual’s retirement date may dramatically reduce the value of assets, therefore reducing the annual pension with no opportunity to benefit from future positive investment returns. This can be partially mitigated by ‘lifestyling’, which transitions assets from risky equities to lower risk bonds and cash in the period to retirement.
There are two main reasons why DC investors may benefit from adopting a more flexible approach to fixed income. The first relates to market conditions and the second to changes in lifestyle, regulation and demographics:
In the current environment of low prospective returns to many asset classes, it is beneficial to be able to take advantage of a wide range of markets and instruments to build a portfolio that maximises return potential. A flexible approach can also allow a skilled asset manager to dynamically change the asset allocation to exploit the changing opportunities. Fixed income exposure also remains a desirable portfolio diversifier, especially in periods of market volatility, where many assets experience simultaneous underperformance and high-quality fixed income typically benefits from a ‘flight-to-quality’.
Individuals can increasingly look forward to greatly improved longevity, and they have more diverse choices in their transition from work to retirement, including part-time working and the option to ‘draw down’ their assets in retirement rather than purchase an annuity. The investment approach described can therefore extend beyond retirement, with the accumulated assets used both to meet spending needs and to generate asset growth. The diversified approach, employing equity, flexible fixed income, other multi-asset funds and active management, allows DC investors to benefit from ongoing growth potential in asset markets and manager skill.
John Dewey is managing director within the BlackRock Multi-Asset Client Solutions. Stuart Jarvis is managing director, Client Strategy at BlackRock
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