Seizing the moment in fixed income markets

This is an excerpt from the full report on the state of public pension plans, which takes an in-depth look at the investment allocations of more than 120 plans and offers insights on changes that plans could make to potentially improve their risk/reward profiles.

Today, the average plan has just a 20% allocation to fixed income, and about one in five plans hold less than 15%. This was appropriate in the era of ultralow yields, but that era has ended. Now that shorter-term yields are above 5% – more than five times their average level between 2008-2022 – plans have an opportunity to potentially reduce their absolute risk and diversify their factor exposure.

Between 2008-2022, the one-year treasury yield averaged just 0.87%, which meant that the remaining 75% of the portfolio needed to return more than 9% to hit the 7% return target, as seen in the left side of the Taking the pressure off of growth chart. Fast forward, with one-year treasuries yielding 4.85% as of June 30 (and higher today), and the rest of the portfolio needs to return less than 7.75% to meet the same return target.

With yields having quintupled, there is clearly room for plans to increase their fixed income allocation. But by how much? That depends on a number of factors, but perhaps chief among them is how much plans expect the rest of their portfolio to return.

On the right side of the Taking the pressure off of growth chart, we look at three different return assumptions (8%, 8.5% and 9%) for the non-fixed-income portion of the portfolio and find that plans could allocate between 32% and 48% to fixed income and still meet a 7% return target.

Of course, a 48% allocation to fixed income would be a radical departure from the status quo for most plans, as the average allocation is currently just 20%. And to be clear, we are not advocating doubling the fixed income allocation, but the findings of this analysis should provide an impetus for pensions to reconsider the size and purpose of their fixed income allocations, across both public and private markets.

If plans decide that they do want to increase their fixed income allocations, there is no shortage of assets that can deliver both yield and diversification in today’s market. Moving out of equities and other growth-oriented assets and into fixed income will naturally shift the risk exposure of the overall portfolio away from the economic-growth factor and toward the real-rates factor. Given that economic growth accounts for more than three-quarters of the average plan’s risk exposure, this may be a desirable outcome for many plans.

While the potential future paths of interest rates and economic growth are highly variable, pensions have a clear opportunity to act in the present to take advantage of the current interest-rate environment.

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