Last year was full of surprises, but the macroeconomic trends we anticipated – a gradual rise in interest rates and inflation – seem likely to continue in 2017. Yet as we acknowledged in March in our Cyclical Outlook, “Scaling It Back,” there is continued left- and right-tail risk associated with the Trump administration’s fiscal and trade policies, elections in Europe and China’s debt bubble. In our view, this underscores the continuing benefits of active fixed income strategies that seek to provide diversification, generate income and mitigate the risks of higher inflation and rising rates.

In partnership with our defined contribution (DC) clients and their advisors and consultants, we suggest five investment themes to guide plan sponsors in navigating the challenges ahead.

GO ACTIVE WITH BONDS

Plan sponsors, facing increasing fiduciary pressure to keep investment fees low, have been considering moving away from active strategies, particularly within stock portfolios. But when it comes to active management, we believe Bonds Are Different. In fact, in the context of net-of-fee returns, passive bond strategies may be the most expensive fixed income option.

Indeed, 84% of active managers in three of the most common DC bond categories beat their median passive peers over the last five years, whereas only 41% of active equity managers outperformed their median passive peers, according to Morningstar (see Figure 1).

We believe there is an active advantage for bonds that relates chiefly to structural features of the market:

• The bond market is large and complex. Perfect replication of a passive bond index is nearly impossible, and may result in higher tracking error and transaction costs relative to equity index replication.
• Major indexes may underweight attractive sectors. Passive strategies tied to benchmarks such as the Bloomberg Barclays U.S. Aggregate Index have high concentrations of low-yielding government and government sponsored securities. They may have little-to-no exposure to more attractively valued sectors of the U.S. and global bond markets, such as non-agency mortgages, high yield and emerging markets.
• Non-economic investors play a major role. Central banks, commercial banks and insurance companies – institutions that have primary objectives other than total return – hold nearly 50% of fixed income securities.² Their presence creates significant opportunity for active managers, who operate with few constraints and focus on the generation of risk-adjusted total returns.

In our opinion, low expected returns only enhance the potential benefits of active fixed income management. For example, let’s say an investment manager can produce alpha of 100 basis points (bps) after fees. This would increase returns by nearly 30% relative to PIMCO’s 10-year capital market assumption of 2.88% for intermediate bonds. Importantly, active managers also have the potential to mitigate the risks of rising rates and heightened volatility and seek to increase absolute risk-adjusted returns by taking off-benchmark positions.

RETHINK THE CORE

We’re at an inflection point for bonds. With interest rates on the rise, plan sponsors need to rethink their core bond options.

Over the past four decades, defined by generous starting yields and steadily declining interest rates, core bonds for the most part delivered the concurrent benefits of capital preservation, equity diversification and income. Today, the fixed income landscape is more challenging, with starting yields of 2.6% and the potential for rising interest rates.

In the market environment just described, the most common core bond benchmark, the Bloomberg Barclays U.S. Aggregate Index, may less effectively perform its traditional capital preservation role, given that its risk profile is defined almost entirely by duration or interest rate risk. Over the coming 10-year period, we expect this index to deliver returns well below the 4.6% annualized return of the past 15 years ended last December.

We suggest three critical modifications to optimize bond allocations for the challenges ahead:

• First, expand the opportunity set by employing diversified bond allocations representative of the broadest global bond opportunity set.
• Second, increase tactical duration flexibility to mitigate downside risk.
• Third, focus on income as a driver of total return, allocating dynamically across global credit markets to capture a premium above government bonds.

Multi-sector bond strategies may play an important role in satisfying these needed characteristics.

Of course, implementation within a DC plan is easier said than done. Some plans have chosen to add credit, multi-sector or global oriented strategies alongside their core bond option. However, the realized benefits of such an approach may be limited given participant inertia and return chasing, which may lead to misallocation of risk and poor returns.

A more effective approach may be to consolidate active bond options into a single, optimal multi-sector solution, either prepackaged or in white-label form.

QUALIFIED DEFAULT INVESTMENT ALTERNATIVE (QDIA) CONSIDERATIONS

The use of target-date funds (TDFs) as default investments has led to greater portfolio diversification than would have been achieved in many portfolios constructed by participants.

Yet, in our view, many TDFs remain insufficiently diversified. Consider that 15 years short of retirement, the market-average glide path has roughly 70% of assets allocated to equities, according to Morningstar. Just 10 years short of retirement, roughly 60% of assets remain in equities.

In particular, we believe many are too long on U.S. equity risk and too short on exposure to diversifying return drivers such as emerging market debt and equity, high yield debt, commodities and real estate investment trusts (REITs) – asset classes that may generate compelling returns in an era of rising interest rates and higher inflation expectations.

Equally important is the use of diversifying exposures to asset classes with the potential to mitigate volatility and preserve purchasing power, such as global bonds and Treasury Inflation-Protected Securities (TIPS).

Regrettably, many Americans saving for retirement are behind where they need to be. We encourage plan sponsors to review their TDFs to ensure they have adequate exposure to diversifying assets needed to help reduce overall volatility, produce better risk-adjusted returns over time and to help participants stay the course.

CONSIDER STABLE VALUE

Many DC record keepers and money market fund (MMF) complexes reacted to the SEC’s sweeping reforms of MMFs last October by consolidating assets into government MMFs. Unlike Prime MMFs, government MMFs retain the objective of seeking a $1.00 net asset value; in addition, they are not subject to the potential imposition of fees or redemption gates.

Unfortunately, this growth has created a vicious cycle: Amid limited supply, increased demand for government paper will likely keep nominal yields of government MMFs low – and real yields negative.

Fortunately, plan sponsors have several attractive MMF alternatives with varying levels of additional risk, including short-term bond funds and white-label (or custom) solutions. Stable value, however, remains the generally preferred alternative. According to the Stable Value Investment Association, stable value assets grew by $43 billion to a record $821 billion in the year ended 31 December 2016. According to the Aon Hewitt 401(k) Index as of 31 December 2016, 12.9% of plan assets were invested in stable value strategies versus only 1.4% in money market funds.

Indeed, with rates likely to rise from generational lows, now may be a particularly attractive entry point for new stable value investors. However, we encourage plan sponsors to review their stable value manager and confirm their ability to provide value even during volatile market periods.

MITIGATE INFLATION

Inflation has been quiescent for so long that many retirement investors have overlooked its potentially corrosive effects. But for defined contribution plan portfolios designed to stretch over decades, we believe inflation remains one of the greatest potential risks, making inflation hedging assets critical. Compounded over years and decades, even 2% inflation can devastate savers’ purchasing power.

Inflation and inflation expectations have increased steadily over the past year, and we believe long term inflation risks are skewed to the upside – so now may be a potentially opportune time to add inflation-focused assets to portfolios. PIMCO expects U.S. inflation in 2017 to be 2.0%, up from 1.3% in 2016.

Perhaps not surprisingly, the majority of respondents to the 2017 PIMCO DC Consulting Support and Trends Survey support offering a variety of inflation hedging strategies in a DC plan’s core investment menu and custom target-date strategies. One way to help protect against the threat of inflation is to embrace a broad set of diversifying real assets such as TIPS, commodities and REITs. Multi-real asset solutions may offer a convenient way to seek diversification across inflation fighting assets, protect purchasing power and limit volatility relative to stand-alone options such as commodities.

THE YEAR AHEAD

As the Fed continues to hike rates and with a new administration in Washington, D.C., the year ahead promises to be one of uncertainty and surprise. Whether it’s bonds, TDFs or stable value, active fixed income management has the potential to provide diversification, generate income and mitigate the risk of higher inflation and rising rates.