Finessing Fixed Income to Meet Public Pension Targets

The high interest rate environment has helped public pension plans’ efforts to close their funding gaps. Yet, according to Equable Institute’s State of Pensions 2023 report, as of the end of 2022, plans’ unfunded liabilities exceeded $1.5 trillion.¹ Investment returns, a critical component of plan health, are one way to help fill the funding gap. However, returns have declined from the 8% levels that plans have historically relied on. While plans have lowered their assumed rate of return to an average of 6.9%, they are unlikely to meet the revised target: Through June 30, 2023, preliminary returns for state and local plans averaged 5.3%.

The current inflationary environment increases the challenge, as public sector wage growth, along with cost-of-living adjustment (COLA) provisions, is likely to increase liabilities further. High inflation has also weakened financial markets, driving down plan asset prices and lowering plans’ funded ratios.

In this challenging environment, public plans need portfolio solutions that have the potential to boost returns and improve their funded ratio. While many have turned to private markets for sources of return, they may also find opportunities to boost return in the public portions of their portfolios. Within public equities, plans can benefit from close attention to the drivers of return. In addition, simplifying and potentially increasing exposure to fixed income can play a valuable role in meeting risk and performance objectives.

Identifying Sources of Return in Public Markets

Public markets deliver value for multi-asset plans by offering access to an array of investments, ranging from specialized funds in niche sub-sectors to broad market coverage. The vast amount of data available means there is transparency in valuations, and the liquidity of publicly traded assets can help manage cash flow within the plan.

When seeking to maximize equity returns, public plans should aim to first get the most of their beta exposures, then look for incremental return. Fortunately, with the right allocation, owning equity beta in a diversified portfolio will likely provide the bulk of the targeted return. For example, U.S. large cap equities that exhibit quality characteristics are one likely source, especially given broad worsening of fundamentals and a weaker earnings outlook resulting from a more muted consumer. (See Public Markets Outlook.) However, in this challenging environment we would advise investing with prudence. Moving forward, adding active managers should be done selectively and prudently to achieve some incremental return while being mindful to avoid overdiversification.

Public plans have several options for seeking incremental returns. Active management within equities may provide alpha, as we anticipate that the global macro environment will slow down, resulting in market volatility, as many regions deal with tight credit conditions, anemic growth, and geopolitical tensions. Active managers’ track record here is noteworthy: Over a rolling three-year-period through June 30, 2023, we’ve seen active managers have success in China, emerging markets, and U.S. small and mid-cap. These managers have struggled within U.S. large cap and European equities.²

Within fixed income, public plans may need to go beyond investment-grade issues to reap the benefits of a higher yield environment. To enhance returns over an aggregate bond or investment-grade corporate debt allocation without taking on unacceptable levels of risk, they might consider high-quality high yield bonds and emerging markets sovereign debt in both local and hard currency.

Fixed Income Sources of Incremental Return

When looking to generate fixed income returns, public pensions should begin with the basics, according to Matthew Nest, global head of Active Fixed Income at State Street Global Advisors. “At the end of the day, plans need to figure out how much rate risk, and how much credit risk, they want overall,” he says. “The vast majority of any allocation within fixed income can be explained by those two simple factors.”

With those decisions made, public plans can make further refinements to their fixed income allocations. In addition to moving beyond investment grade issues, plans can consider issues including investment style—specifically, indexed, systematic, and active investments.

Indexing

Given the availability of index options for nearly every sub-asset class, public plans can use indexing across their fixed income portfolios. Index funds offer the experience investors expect, at low cost and with precise tracking of the relevant benchmark.

Public pensions may be particularly interested in using an indexed solution for high yield bonds, which can help them take advantage of widening spreads during market dislocations. A high-yield index fund can provide exposure to higher yields with lower tracking risk than active high yield strategies, while more consistently capturing market beta. For public pensions that have turned to private markets in search of greater yield and potentially higher returns, indexed high yield can serve as a complement, as it is the closest liquid proxy for private credit.

Indexing may also add value in emerging market debt (EMD), where active managers have often experienced outperformance in up markets and underperformance in down markets due to factors including herding behavior and loss aversion. Meanwhile, improvements in EMD liquidity have made an indexing approach much more feasible — sophisticated portfolio construction and sampling techniques mean that index managers can closely track index returns and, when combined with lower index costs, can rival the net performance of active portfolios.

Systematic Investing

Systematic active fixed income (SAFI) strategies use disciplined, data-driven portfolio construction techniques to seek higher returns, without increased risk, than could typically be achieved through indexed vehicles. State Street Global Advisors collaborates with the Barclays Quantitative Portfolio Strategy team (QPS) to build portfolios based on quantitative signals that help identify unique sources of risk and return in fixed income markets. For example:

• In the relative value signal, our algorithm can analyze a wider range of bonds to identify those that are priced better than their peers after controlling for risk characteristics and fundamentals.
• Our cross-asset momentum signal goes beyond credit quality to look at each corporate bond issuer’s equity performance—differentiating credit issuers by identifying those whose prospects may be improving based on positive equity returns, and those that may have declining prospects based on poor equity returns.
  
• Our sentiment signal analyzes equity short positions to identify issuers that tend to underperform their peers.

Each security receives a score for each signal, as well as a composite score based on a weighted combination of the three signals. A systematic strategy selects securities with high composite scores, allowing us to optimize portfolios to generate a differentiated return stream—one that is distinct from both market alpha and returns arising from fundamental analysis.

We’re able to take these steps thanks to the rise of electronic trading for bonds, which has increased transparency. The explosion of data on pricing, liquidity, risk characteristics, and other aspects of the market allow us to uncover and take advantage of opportunities in a cost-effective way. “A lot of this low-hanging fruit used to be solely the domain of active managers,” says Nest. “But increasingly it’s available through a systematic approach.”

SAFI strategies can be used as either a replacement for a core fixed income allocation or as an indexed addition to the portfolio, intended to add incremental alpha at lower cost than an actively managed strategy. The keys to success with SAFI, Nest says, are deep experience with fixed income research, pragmatic understanding of how portfolios and markets behave, and a sizeable footprint in fixed income. With these elements in place, Nest says, “it’s possible to tap into a different excess return stream relative to what you may currently have.”

Short Term Active Management

For public pensions that are looking for exposure to active management, actively managed exchange-traded funds can serve as a short-term solution during the often-lengthy search process for active managers. Active ETFs are able to navigate around the Bloomberg Aggregate Bond Index’s rule-based constraints and pull from a broader set of securities to seek improved returns, reduced risk, and enhanced diversification.

Public pensions might consider the following actively managed funds as interim solutions:

• SPDR Loomis Sayles Opportunistic Bond ETF (OBND). With this fund, the Loomis Sayles team aims to produce strong risk-adjusted returns over all stages of the market cycle, with a multi-asset credit strategy that includes access to all fixed income sectors and issues of any credit quality. In late 2023, they see a strong likelihood of a recession in the next 12 to 18 months. As a result, “We’re pretty conservatively positioned in terms of credit quality,” says Kevin Kearns, a portfolio manager and head of the alpha strategies group at Loomis Sayles. “We also want to position the portfolio so that it’s liquid. That way, if the markets do go into significantly volatile times, we can take advantage by buying the most dislocated securities.” Ultimately, Kearns says, the fund allows public pensions to add a layer of tactical credit asset allocation so they can capture excess returns over time not only from bottom-up security selection, but also take advantage of market dislocations and relative value between sectors and credit quality.
• SPDR DoubleLine Total Return Tactical ETF (TOTL). Broadly speaking, DoubleLine aims to produce incremental return in fixed income without excess risk via a diversified mix of credits, as well as agency mortgages, commercial mortgage-backed securities, and Treasuries. Like Kearns, DoubleLine Portfolio Manager Jeffrey Mayberry sees a recession ahead. As a result, the fund is currently taking advantage of rising Treasury yields to reduce credit risk in the portfolio. This positioning also extends its duration to match the Bloomberg Aggregate Bond Index—a contrast to the fund’s typical shorter duration position. The fund also holds a 20% allocation to agency and non-agency mortgages as well as some high yield issues, which also have a shorter duration. Together, these positions offset some of the longer duration exposure in the fund’s Treasury holdings. Public pensions typically look to the fund as a fit for their longer investment horizons, while also providing the active management that can take advantage of opportunities that might arise in the shorter term.
• SPDR DoubleLine Short Duration Total Return Tactical ETF (STOT). Run by the same asset allocation team as Total Return Tactical, the Short Duration Total Return Tactical ETF prioritizes lower volatility and lower risk. The fund invests in a mix of agency mortgages, Treasuries, floating rate loans, and AAA-rated collateralized loan obligations (CLOs), looking for opportunities to add incremental yield without taking on additional risk. Mayberry sees the fund as a good fit for investors that are shying away from longer durations in the wake of rising rates but are still looking for incremental return. “We are in an environment where shorter duration and higher yield accomplishes that,” he says.

Managing Complexity in Public Pensions

Public pension plan sponsors face increasing challenges in generating returns and ensuring the health of their plans. Fortunately, in the search for incremental returns, they can deploy several tools, beginning with careful assessment of equity asset allocation strategies. From there, public pension plan sponsors should also look closely at their fixed income allocations, which can play a valuable role in meeting risk and performance objectives.

As they consider fixed income allocations in particular, public pensions may benefit from combining active, systematic, and indexed styles. For example, paired together, a high-yield index fund and an actively managed aggregate bond fund can strike a balance between de-risking and return-seeking.

State Street can help assess public pension plans’ current allocation and make recommendations for enhancements. Reach out to learn more about how we can help.