Industry Voices

Uncovering Hidden Risks in Fixed-Income Target-Date Fund Allocations

Brett Wander and Jake Gilliam of Charles Schwab say plan sponsors should consider re-examining their TDF fixed-income allocations, with an eye toward identifying potential heightened downside exposure risk.

By PS | July 18, 2017
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Most plan sponsors would agree that the primary goal of the fixed-income strategy inside a target-date fund (TDF) is to help protect assets against market volatility, particularly as participants near retirement. But whether plan sponsors realize it or not, that effort may have been compromised in some TDFs over the last several years.

In an effort to combat years of incredibly low interest rates, some active fixed-income strategies held in TDFs may have taken on additional risk within their portfolios. As a result, some TDF fixed-income exposures risk the potential of behaving more like equities than bonds, today. And the timing couldn’t be worse—an elevation in fixed-income risk can jeopardize accumulations when participants are at their most vulnerable, as they near retirement.

Given that, plan sponsors should consider re-examining their TDF fixed-income allocations, with an eye toward identifying potential heightened downside exposure risk. Below are three things to look out for, along with some guidance regarding how, potentially, to respond.

Additional Risk-Taking

Many TDFs rely exclusively on active fixed-income strategies, which seek to capture incremental return advantages in higher-yielding credit segments. At the same time, almost a decade of generally strong credit markets has led some to feel a false sense of security about exactly how much additional risk this “stretching for yield” potentially entails.

As an illustration, consider how the goal posts have moved over the last several years for fixed income managers aiming to secure a 5% yield. In 2007, that could be done with virtually no credit risk using U.S. Treasury securities. Two years later, investors would have needed to invest in U.S. corporate investment-grade bonds to achieve that same coupon level. Today, a similar 5% coupon would require venturing into Ba-rated U.S. high-yield bonds, representing a significant elevation in credit risk relative to U.S. Treasurys.

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