Fixed-income diversification will take center stage as interest rates and inflation rise
Expect fixed-income diversification to become the next focal point as 401(k) plan advisers try to protect participants from rising interest rates and inflation, along with fears of a bond bubble.
Low yields on bonds, along with a search for fixed-income options that aren't directly tied to low interest rates in the United States, are pushing plan advisers to look into other options for 401(k) menus, including high-yield and international bond funds. Indeed, higher prices on bonds as of late have been eating into their yields.
“Plan sponsors are showing a concern about the bond market being frothy, but people see the bond market as being monolithic and don't understand that they're more diverse than equities,” said Ken Waltzer, president of Kenfield Capital Strategies.
"NARROW' OFFERINGS
“Bond offerings are very narrow in 401(k)s. Often, one offering is a government or Treasury fund and the other might be tied to the Barclays Capital U.S. Aggregate Bond Index,” Mr. Waltzer said.
One of the biggest arguments in favor of expanding fixed-income offerings is the exposure to global bond markets, where factors governing returns differ from those in the United States.
For instance, the top-performing currency and bond markets in recent years include New Zealand and the Scandinavian nations, and some emerging markets, according to Robert Tipp, head of global bonds and foreign exchange in Prudential Financial Inc.'s fixed-income department.
“We think there's some value to getting exposure to the global environment when you think of interest rate risks,” said John Ameriks, a principal at The Vanguard Group Inc. “Inflation and economic growth rates vary wildly around the globe, so the factors influencing bond markets and their returns will be different.”
Although single-digit interest rates are the norm, the chance of rates spiking suddenly still exists, Mr. Ameriks said.
“We should never ignore that risk,” he said. “That's the argument for global exposure.”
GENERATING DISCUSSION
In the second quarter, Vanguard will release a low-cost international bond index fund and exchange-traded fund. The company will make the funds available to plan sponsors that want to offer a stand-alone option, and also integrate them into its target date series.
High-yield bonds are generating a lot of discussion because of their earnings potential and diversification.
They have made their way into open-architecture 401(k)s as a component of a customized bond portfolio, Mr. Waltzer said.
“High yields give you higher risk but a higher potential for return, plus lower sensitivity than a broad- market fixed-income fund,” Mr. Tipp said. “If you're going to add more options, particularly in the low-yield world we're in, it's high yield.”
