As yields have remained low in the post-crisis era, investors’ expectations have shifted to reflect this reality. This shift can be seen in the return targets of public retirement plans, where according to National Association of State Retirement Administrators (NASRA), of plans surveyed “nearly threefourths have reduced their investment return assumption since fiscal year 2010, resulting in a decline in the average return assumption from 7.91 percent to 7.36 percent.”
For the segment of investors that use market-based interest rates to discount liabilities, an increase in rates is almost invariably positive for funding ratios. An increase in rates should cause liabilities to decline more rapidly than assets. For example, a $1 million liability ten years from now assuming a rate of 2.74% (the ten year Treasury at the end of the first quarter) versus 2.41% (the rate at the end of 2017) declines in present value from $786k to $760k, a decline of about 3.5%. With liabilities instantly shrunk as discounting rates increase, the need to achieve higher returns diminishes on the margin.
On balance, with fixed income able to deliver a higher percentage of these lower targets as rates rise, this increases the appeal of fixed income broadly.
The four elements—other than earth, wind, fire and water
The illustration of generating a target yield within fixed income is particularly important in the context of investors’ return targets and this period of low rates has impacted the role of fixed income in investors’ portfolios. In the context of broad asset allocations, while generally not viewed as a primary driver of returns, fixed income has historically served four distinct purposes: income, diversification, capital preservation and liquidity. As yields dropped post-crisis, these factors have come into odds with one another rather than working in harmony. For example, achieving a 5% yield has gone from a simple task to somewhat more involved. Twenty years ago, the Bloomberg Barclays (Lehman back then) Treasury index yielded above 5%, reflecting that a pool of Treasuries across the maturity spectrum, could generate this target yield. A pool of Treasuries is the very definition of capital preservation and rate exposure has been the historical driver of fixed income’s diversification benefit against equity risk.
Since that time, however, the composition of fixed income assets needed to generate a 5% yield has shifted meaningfully. As Treasury yields declined and Treasuries alone could no longer meet the 5% yield, the next phase was a more core-like mix including mortgage backed securities and credit. This more core-like mix still offered all four elements, though in not as pure a form. As yields continued to decline, more recently Treasuries had to give way to allow high yield debt and other “plus” sectors, culminating in 2017 with a portfolio requiring 70% high yield to generate the yield target. Investor interest appears to have followed this trend of changing assets mix. This is significant as the more recent sector blend offers income, but compromises the diversification, capital preservation and liquidity facets.