Thought Papers

Bonds, What Are They Good For?

When constructing a diversified portfolio, often one of the first decisions considered by investors is the allocation to bonds, as they add stability to investment portfolios and generate a predictable stream of income, even when stocks underperform.

The predictability of bonds is especially useful for state and local government retirement systems. The assets within these systems are invested to pre-fund the cost of pension benefits. The returns on these assets matter, as investment earnings account for a majority of public pension financing. Therefore, when pension plans make their allocation decisions, the predictability of revenue generated through bond ownership becomes very important, and the best predictor of a bond’s future return is the starting yield. The lower the starting yield, the lower the future return. Even in a protracted downturn, bonds may not provide the same level of absolute protection as they have historically. That’s because the ability for rates to decline from today’s starting point has been compressed, and it is generally accepted that they are capped at zero. With interest rates having been held at low levels since 2009, and Federal Reserve Chairman Jerome Powell announcing that they could remain ultra-low for years, the question becomes: What role should bonds play in state and local government retirement system portfolios?

The Investment Return Assumption

Most public pension plans use projections to determine what level of return their plans will need to achieve to meet future pension obligations. This return assumption helps state and local government retirement systems determine their asset allocation.

According to the National Association of State Retirement Administrators (NASRA), “The investment return assumption is the single most consequential of all actuarial assumptions in terms of its effect on a pension plan’s finances.” That is why many pension plans consult with investment experts to establish accurate return assumptions. As of September 2020, the average investment return assumption for public pension plans measured by NASRA was 7.17%. In other words, public pension plans need to meet a long-term net rate of return of 7.17% to meet all of their obligations.

Asset Allocation

Once public plans understand what their investment return assumptions are, they can craft their asset allocation around the assumptions to meet their investment goals. NASRA’s December 2019 Public Fund Survey highlighted the average asset allocation for public funds, as shown in Figure 1.

Figure 1: Average Public Fund Asset Allocation

Source: publicplandata.org

Based on information collected in 2019, fixed income represents the second-largest allocation in portfolios behind equities for most public pension plans.

Meeting Return Expectations

With fixed income or bonds making up nearly a quarter of public pension plan portfolios, every trustee should consider how the new market environment with ultra-low interest rates will impact return assumptions. Using the asset allocation summary from NASRA and Vanguard’s long-term asset class return outlook, it is possible to estimate the long-term return expectations for equities, fixed income, real estate, and cash. Although it is difficult to estimate the long-term return expectations for alternatives, it is still possible to identify what the alternatives return would have to be for public plans to meet their investment return assumption of 7.17%. As depicted in figure 2, public pension plans would be leaning on their alternative allocations to provide a significant portion of future returns, needing a long-term return of over 15% in order to meet assumptions.

Figure 2: Public Pension Plan Return Expectations

Weight Source: publicplandata.org | Return Expectation Source: Vanguard
Note: Past performance is not indicative of future results.

Alternatives have the ability to outpace public market returns and can be an essential diversifying component for any portfolio. That said, expecting a single asset class to generate a long-term return above 15% is a very lofty goal. In addition, having such a large allocation to alternatives might not be possible for all public plans.

The real issue with these return expectations is not alternatives; instead, it is the miniscule future return expectations for the fixed income asset class. With interest rates remaining at record lows and no expectations for them to increase, trustees are in a difficult position when 22.8% of their portfolio is only expected to provide a long-term return of 1.8%.

What Can Trustees Do?

Most public pension plans are required to allocate a certain percentage to fixed income based on local regulations. However, allocating to fixed income is not always a bad thing. During market corrections, for example, fixed income allocations can provide a significant amount of value to portfolios. In figure 3, the performance of the U.S. Aggregate Bond Index is compared to that of common equity indices during market corrections.

Figure 3: Asset Class performance During Market Corrections

Source: eVestment
Note: Past performance is not indicative of future results.

As demonstrated above, even if it is not to the extent it used to be, fixed income can still provide value during market drawdowns. So, how can trustees balance the positive aspects of fixed income during corrections with the low return expectations due to the interest rate environment we have today?

Option 1: Alternative Investments

One-way trustees are looking to boost return expectations without reducing fixed income exposure is by allocating additional resources to alternative investments. Alternative investments typically outperform during market corrections because they are uncorrelated with public markets and, as a result of the illiquidity premium, can provide outsized returns when markets are doing well. However, most public plans already have a significant amount of assets dedicated to alternatives investments. Another consideration for trustees, especially in the state of Georgia, is the limited allowable exposure to alternatives based on state law. As such, further allocation to the asset class may not be possible.

Option 2: Tactical Multi-Asset Managers

A secondary option that public plans are beginning to consider is the addition of a tactical multi-asset manager. Tactical multi-asset managers can allocate to both equites and fixed income, while tactically shifting between asset classes based on which one is poised to outperform. This means that tactical multi-asset managers have the ability to outperform during long, sustained bear markets by quickly allocating to fixed income, and they can keep pace with broader equity indices during bull markets.

Take-Aways

Given recent comments made by the Federal Reserve, it is likely that interest rates are going to remain very low for the foreseeable future. Therefore, the return expectation for bonds is likely going to be low for years to come. Based on current allocations and return expectations, pension plans are going to find it extremely difficult to meet their return assumptions. Whether it be through increasing alternative investment exposure or introducing tactical multi-asset strategies, trustees must consider a variety of options to meet return assumptions in this ultra-low interest rate environment.

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