In retirement, why are bonds important? 

Investing in equity seems to be the focus of most asset allocation discussions. There are valid reasons for this: Equity accounts for the majority of capital gains that determine retirement sufficiency. 

Fixed income plays a crucial role in the critical transition and retirement phases, which makes asset allocation a powerful retirement tool. Fixed income allows for risk-adjusted asset allocation. 

Fixed income’s four roles- 

The financial risks an investor faces and a bear market may cause losses that are difficult to recover from. Bonds’ interaction with equities can help mitigate these risks. Bonds should have distinct roles in asset allocation. 

Assuming that equities are the primary asset class in an asset allocation strategy, a modest allocation to conservative bonds with low or negative correlation to stocks can help mitigate market risk. 

• Income: Bonds are required for retirement income. Bonds can provide high total returns and yields with low risk. 

• Inflation protection: Inflation-linked bonds can protect purchasing power (a source of long-term inflation protection). 

• Capital preservation: In retirement, high-quality, low-duration bonds can help protect capital from market and interest rate risk. 

Active vs. passive bond funds-

While passively managed funds generally have lower costs, implementation issues exist. As a result, they tend to favor larger issuers with higher borrowing needs, which may not represent the best opportunities. Bond indices can be costly or difficult to replicate (due to liquidity issues and index changes). The choice of benchmarks has a big impact. Also, keep in mind that a benchmark’s risk profile can change over time as its duration and credit quality follow the borrowers represented. 

Active funds have higher management fees. Also, the investment manager’s incentives may not be aligned with end-investor goals. For example, a bond fund manager may be motivated to outperform his peers, even if this means taking credit risk and suffering large losses in bear markets. This goal does not automatically make the fund a good fit in a broader allocation strategy that uses bonds to cushion equities market shocks. 

Actively managed bond funds are not required to take on the risks of specific credits just because they are included in an index, nor to mechanically track any escalation in the index’s aggregate risk. 

Where do the bonds go? 

Now let’s look at two unique sub-classes of fixed income — inflation-linked and high-yield bonds — within the context of asset allocation.

Inflation-linked bonds protect against inflation shocks. When moving from accumulation to distribution, the risk of losing purchasing power increases as equity exposure decreases. 

As the US Consumer Price Index rises, the bond’s principal increases, leading to higher coupon payments and a higher principal repayment at maturity. Also, the maturity repayment will not be less than the original principal. 

This predictability comes at a cost: lower expected returns. In recent years, TIPS real yields have been negative. Also, like nominal bond returns, TIPS returns are affected by changes in real yields. So, use TIPS carefully, along with other tools. 

In terms of high-yield bonds, it’s important to separate equities from corporate bonds. They each expose a company’s capital structure. Market conditions, relative value, and the investor’s needs determine where to invest in the capital structure. 

Overall-

The fixed income allocation is meant to protect against downturns. An allocation should be able to shift credit quality, duration, and geographic exposure to match market conditions. 

Exposures must be changed from the top down in passive approaches, where underlying fund managers are constrained. It lacks the nimbleness of fully active approaches where flexibility is built-in.