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Defined Contribution

Variable-rate bonds showing up in DC portfolios as inflation hedge

Ortec Finance’s Martijn Vos

Floating-rate bonds are making an appearance in U.S. and European defined contribution portfolios as executives grapple with growing inflationary pressure, managers say.

In the current rate environment, life-cycle and target-date fund strategies, which typically hold government bonds or investment-grade corporate bonds, don't provide plan participants with the right level of protection against increases in inflation. As interest rates are set to move upward around the globe, plan executives are concerned that failing to achieve returns at least in line with inflation will erode retirement savings, consultants said.

"Inflation risk is higher now than few years ago and the original glidepath is too static because it starts derisking too late in the retirement journey," said Martijn Vos, managing director and partner, pensions and insurance, at risk management firm Ortec Finance, in Rotterdam, Netherlands.

These worries have DC plan executives taking another look at how they are protecting default portfolios against the detrimental effects of inflation, sources said. As they move closer to retirement, participants need more complex risk-reduction techniques to protect accumulated savings against incurring last-minute losses.

The point at which investors start to draw down savings matters, especially when interest rates are increasing. And as participants retire, inflation risks could be amplified as they dip into the retirement savings continuously rather than taking a lump sum, sources said.

"Clients are realizing that due to the market conditions, a hybrid glidepath with both descending and ascending elements is needed," Mr. Vos said.

Money managers running DC assets said floating-rate bonds such as high-yield debt, asset-backed securities, leveraged loans and Treasury inflation-protected securities can help shield portfolios against inflation because they have a shorter duration than other common fixed-income assets.

According to Morningstar Inc., flows into U.S. open-end funds investing in bank loans were at a three-year high, with total net assets at $125 billion as of March 31, and were up 7% year-over-year.

Worried about low returns

"Defined contribution plans are having the same concerns as defined benefit plans over lower returns as we move closer to the end of the 10-year cycle," said David Vickers, senior portfolio manager at Russell Investments in London.

"Clients want return above inflation and they have been moving up the risk spectrum," Mr. Vickers added. "We recommend high-yield debt, convertible bonds and asset-backed securities."

Matthew Maleri, partner and managing director, asset allocation, at Rocaton Investment Advisors in Norwalk, Conn., agreed. The demand for bank loans, leveraged loans and some floating-rate asset-backed securities from DC clients has been growing steadily in the U.S. in the past three years, Mr. Maleri said.

"We are seeing 1% to 2% higher inflation relative to where we have been in the last 10 years, so clients already make use of (floating-rate instruments)."

However, Fraser Lundie, co-head of credit at Hermes Investment Management in London, added that plans seeking to move to high yield from investment-grade securities could be unwisely combining decisions on interest-rate risk and credit quality.

Mr. Lundie thinks exposure to variable-rate debt could be achieved without precluding investment-grade bonds through "duration-light" strategies that use the "full spectrum of credit, including loans, derivatives such as credit index options and government bond futures."

Garrett Harbron, head of U.K. wealth planning research at Vanguard Asset Management Ltd. in London, added, "We don't think high yield is appropriate because of (its) relatively high correlation to equity markets … even if these bonds can offer the inflation protection."

Vanguard implemented a 10% TIPS allocation in its U.K. target-date funds instead, Mr. Harbron said. "For portfolios with small exposure to equities, there is a place for TIPS so you don't have to worry about earning enough money from your equity exposure to cover (the shortfall caused by inflation) on the entire portfolio," he said.

For these reasons, asset owners in the U.S. and Europe have preferred accessing short-duration credit through a multiasset credit strategy, where all these elements including inflation-linked bonds are available, Mr. Maleri said.

Chris Inman, investment principal at Aon in London, said the need for multiasset credit strategies among U.K. plans has become apparent since the country's 2016 vote to leave the European Union.

"Since Brexit, gilts have dropped 12% and have not regained," Mr. Inman noted, adding multiasset credit is a way to offset these losses.

Aon implemented the strategy for two U.K. DC plans in recent months; Mr. Inman declined to name the clients.

Key reasons for switch

The switch is happening in the rest of Europe, too, sources said, for two key reasons. First, the classic descending glidepath design in which bonds gradually replace equities as participants near retirement is not meeting participants' objectives. Also, that gradual process now is coming up against the necessity to reduce bond portfolio durations because of moves — underway or expected — to raise interest rates by the U.S. Federal Reserve and European Central Bank.

Mr. Vos said life-cycle strategies typically used in Europe don't offer inflation protection and many plan executives focus on providing defensive stand-alone investment options rather than including them in the default fund.

Speaking at the PensionsEurope conference in Brussels on June 7, Mr. Vos said: "This is really a key issue. In life cycle, your goals depend on your age, but at the end your savings (journey) includes (the cost of) inflation."

But Mr. Vos added that the firm is seeing movement, noting that Dutch and Swiss plans especially are moving from this type of investment structure "if a simple life-cycle strategy is really not giving you the outcomes that meet your goals."

To date, many DC plans used commodities to protect against inflation. However,Vanguard's Mr. Harbron said, "Commodities were a good hedge in the past, but we are not convinced that this relationship will hold going forward." Added to that, "the cost of accessing commodities is higher than for other asset classes," he said.