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December 3, 2012
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From left: Robert Tipp, Michael J. Collins and Michael Rosenberg
Fixed Income Can Help Enhance Retirement Menus -- Part 2
Prudential Investments Mutual Funds, part of Prudential Financial, spends a lot of time providing thought leadership with input from Prudential Financial's affiliated institutional managers. A topic it has recently given much attention to is fixed-income choices in defined-contribution (DC) plans. Earlier this year it published the white paper, Insights on Investing: Fixed Income Options within DC Plans, for the purpose of initiating dialogue with advisors and consultants.

In this two-part Special Report, Jerilyn Klein Bier, a contributing editor for Financial Advisor magazine, engages in a roundtable discussion with key professionals at Prudential to discuss this topic. The participants included Michael Rosenberg, senior vice president and director of IODC Distribution for Prudential Investments; Robert Tipp, managing director and chief investment strategist for Prudential Fixed Income; and Michael J. Collins, senior investment officer and portfolio manager for Core Plus Fixed Income Strategies at Prudential Fixed Income.

In Part 1 of this feature, published yesterday, the experts explain why offering a wider selection and variety of fixed-income choices to DC plan menus can potentially provide higher returns, greater diversification and less volatility to retirement portfolios.

In today's Part 2, the experts explain how financial advisors can help in this effort.
  Q & A 
  • What types of fixed-income funds can potentially help participants construct better portfolios?
    Robert Tipp: Retrenching into fixed income or into the lowest risk vehicles may help people conserve, but that doesn't find them a middle ground in terms of something that will have a somewhat higher return than a core/core plus fixed-income mandate but with potentially less volatility than equities. High yield bond funds -- and we focus on higher rated high yield -- is one of those middle grounds that could become more of a value generator. It's an asset class that has been very efficient in terms of the amount of return that you get per unit of risk. In fact, higher rated high-yield bonds have among the most attractive risk-adjusted returns of all U.S. asset classes over the long term in my opinion. (Sources: Morningstar, Barclays Capital. Jan. 1, 1997 to June 30, 2012.)

    Since the U.S. dollar has historically been one of the world's weakest currencies (Source: Bloomberg. Represents the trade-weighted U.S. dollar as calculated by the Bank of England, 1/1/1975 to 7/31/2012), diversifying into a global bond fund may help investors protect their purchasing power. Many emerging market countries, for example, not only have favorable growth dynamics relative to the U.S., but also have been reducing their government debt burdens and are, as a result, on a trend of improving credit quality. Also, a number of developed countries, such as Norway, Sweden, Australia, and Canada, have also exhibited strong growth and better fiscal discipline relative to the U.S. To boot, yields found in these bond markets are generally higher than those available in the U.S.

    Collins: If I had to pick three fixed-income choices, it would be a core/core plus bond fund, a high-yield bond fund, and a global bond fund with a fair amount of emerging debt associated with it. As interest rates on U.S. debt have come down, the yields offered by a lot of traditional core bonds are now in the low to mid-single digits at best -- so I believe having a higher yielding fund offering is really timely. [See Figure 1.]
  • What about floating-rate income funds, which are also mentioned in the white paper?
    Collins: Floating-rate income funds, which invest in senior secured loans where the interest rate periodically resets based on changes in a specified benchmark rate, are generally comprised of high-yield or below-investment-grade issues. If rates do go up significantly -- when the Federal Reserve eventually raises rates again -- generally the floating-rate structure of the loans will result in notably less principal volatility than a fixed-rate bond. They should ultimately provide a higher coupon or a higher yield, but with more risk, as well. Also, while loans tend to be less sensitive to economic cycles than high-yield bonds, they are nonetheless a hybrid vehicle between stocks and bonds so I think they can play a role in diversifying a portfolio.
  • What happens with floating-rate bond funds if interest rates remain flat for a while?
    Collins: You basically capture the yield with some potential for price appreciation. That's why now if I had to choose between a high-yield bond fund and a loan fund, or a high-yield bond and a loan, on average, I currently favor high-yield bonds because they have a little more upside potential.

    Tipp: On the heels of the huge decline in interest rates that we've seen in recent years, I believe there's a general misperception by investors that if they stay in cash, they'll be better positioned over the next five to 10 years because at some point, the economy will be better and the Federal Reserve will raise interest rates. But in all likelihood, much of the decline in interest rates from the high levels of the 1970s and early 1980s may very well be permanent. Investors need to be careful that their investments don't have unduly short durations since a shortening on the yield curve will reduce their income and eliminate the natural balancing effect that intermediate- and longer-term fixed-income securities can have on an overall portfolio. Something I think that people have missed to some extent is that intermediate- and longer-term fixed-income portfolios are often a good diversifier since they tend to fluctuate inversely with stock investments.
  • Why should advisors and their clients feel confident about high-yield bonds, given their historically poor reputation, and about global bonds, given the global debt crisis?
    Tipp: While it may seem counterintuitive to allocate to global bonds given the crisis in Europe, one of the potential benefits of an actively managed global bond fund is its ability to rotate among countries to find the best opportunities. In contrast, a single country fund is largely captive to that country's political and economic cycles.

    Collins: To be sure, high-yield bonds have fluctuated with the economic cycle, but over the long term, their generous yield levels have more than offset losses from defaults, which average about 4% a year over the long term. (Source: JP Morgan as of June 30, 2012.) Additionally, if you look at the historical performance of the asset class on both an absolute and risk-adjusted return basis versus other bonds and equities, I believe it looks really appealing. One of the adages is you could get returns competitive with U.S. stock market with about half the volatility (See Figure 2).

    I would never recommend that individuals invest in a handful of individual high-yield bonds. The funds offered on platforms of defined contribution programs tend to be really diversified. We have hundreds of different high-yield bonds in the funds we manage. So investors could capture the positive attributes of the asset class without having the idiosyncratic risk of a default really impacting principal.
  • Are fixed-income investments already benefiting DC portfolios, and what performance period is most relevant to look at?
    Collins: Over the last decade, most bond sectors have outperformed U.S. stocks, with the highest-yielding bonds performing best. [See Figure 3.] So to the extent people have selected bond options in their allocation, it's really provided the ballast -- not only in incremental return and capital growth, but in years like 2008, core bonds had the highest returns. I'd look to at least a five-year performance period. A full cycle is probably really more like 10 years but a five-year number at least to where we are today is a good snapshot because it has the entire 2007 to 2009 weakness and the 2010 to 2011 strength.
  • What should advisors be looking for when selecting fixed-income managers?
    Collins: Finding an appropriate manager is as important as picking the fund and the style of the fund. I think a stable team is really important; you don't want a place where there's a lot of turnover. You also want a team with deep resources, really strong research and risk management capabilities, great systems and processes, and a proven long-term track record that's managed through different economic cycles.

    Tipp: It's important to hire asset managers with a wide range of skills that can use the full spectrum of sectors and instruments available. While a manager using a narrow range of skills may be successful in certain market environments, I believe a manager with broad skills and experience should be able to deliver consistently competitive performance over the long term.

    Rosenberg: You also want a manager who has size and scale to give you access to the right deal flow, at the right price and at the right time. I think you also have to balance size and scale with the ability to be nimble. If you're too big, you might not be able to add alpha by buying the right bonds.
  • You've mentioned using the full spectrum of sectors. Can you give a quick rundown of some sectors advisors may want to think about?
    Tipp: Experienced asset managers -- for core/core plus funds, high-yield bond funds, and global bond funds -- should be actively allocating across sectors to try to capture the most attractive relative value opportunities. U.S. multi-sector managers should be analyzing trends and value propositions across the fixed-income spectrum: government bonds, mortgage-backed securities, structured product, taxable municipal bonds, corporate bonds, and even crossover, non-investment grade, and emerging markets debt. High-yield bond managers must have expertise analyzing the full ratings spectrum of both fixed-rate bonds and floating-rate loans, as well as the European and Asian high-yield markets, where important opportunities also exist. At the global level, astute managers must allocate across all of these sectors, in both developed and developing countries' bond and currency venues.
  • What should advisors and plan sponsors expect from managers who provide fixed-income investments for DC menus?
    Rosenberg: Consistency is the one word that comes to mind for me, as well as sticking to the mandate they're hired for and producing the results that are expected within that mandate. Plans are created and menus are created with very specific intents. So if you hire someone to manage a higher-rated high-yield fund, you want them to manage a higher-rated high-yield fund and not necessarily reach into the lower grade because there's an opportunity there. Information flow -- through attribution reports, manager commentary or fund fact sheets -- is also important.

    Meanwhile, plan sponsors should be working with qualified advisors who focus their efforts on retirement plan markets. To me, that's the most important thing. That person should really have a strong understanding of not only who the players are in the marketplace, but how to evaluate investment choices against some subset or universe that is most relevant. It's not only evaluating performance but evaluating fees, risk and different things about plan design. Making sure you have the appropriate share classes and the appropriate vehicle structure, depending upon the plan size and the economics that you're generating, are really important.
  • When do you expect that fixed-income investments will become a more integral part of DC plans, including QDIAs?
    Rosenberg: Now. Especially with the recent regulations and new changes that have come about, advisors and consultants are looking at menus in their entirety and trying to understand if they have the right QDIA. We're having a lot more conversations about fixed income, high yield, our core/core plus bond platform and our global bond platform.
  • Would you like to add any final comments?
    Rosenberg: The goal of our white paper is not to suggest adding a whole bunch of fixed-income funds at the expense of equity funds, but to make sure plans have enough choices in place to better address the accumulation and retirement income needs of today's workforce. Having a broader mix of fixed-income alternatives can help investors achieve better, more diversified, portfolios, which can potentially lead to greater returns at lower risk. It also provides greater flexibility for plan participants, whether it's through developing an individualized strategy with their financial advisor or in having access to more effective QDIAs.
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  • Barclays U.S. Aggregate Bond Index covers the U.S. dollar-denominated, investment-grade, fixed rate, taxable bond market of SEC-registered securities. Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade debt. Barclays U.S. Government Index covers the total universe of investment-grade fixed income securities issued by the United States government or its agencies. Barclays Global Aggregate Bond Index is an index of global investment grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency, and corporate securities. FTSE NAREIT Equity REITs Index measures the performance of all real estate investment trusts listed on the New York Stock Exchange, the NASDAQ National Market, and the American Stock Exchange. JP Morgan EMBI Global Diversified Index is an index of emerging market debt including USD denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasi-sovereign entities and limits the weights of those index countries with larger debt stocks by only including a specified portion of these countries' eligible current face amounts of debt outstanding. Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. S&P 500 Index is a market capitalization-weighted index of 500 companies primarily traded on the New York Stock Exchange. 10-Year Treasury Note is widely recognized as the benchmark bond in determining interest rate trends.

    Past performance is not a guarantee of future results. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. Indices are unmanaged. An investment cannot be made directly in an index.

    Mutual fund investing involves risks. Some funds are riskier than others. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. High yield bonds, commonly known as junk bonds, are subject to a high level of credit and market risk. Mortgage-backed securities are subject to prepayment and extension risks. Foreign investing involves the risk of currency fluctuation and the impact of social, political and economic change. Emerging markets are considered risky because they carry additional political, economic and currency risks.

    Consider a fund's investment objectives, risks, charges and expenses carefully before investing. The prospectus and summary prospectus contain this and other information about the fund. Contact your financial professional for a prospectus and summary prospectus. Read them carefully before investing.

    Views and opinions are expressed for informational purposes only and do not constitute a recommendation to buy, sell or hold any security. Views and opinions are current as of this presentation and may be subject to change, they should not be construed as investment advice.

    Mutual funds are distributed by Prudential Investment Management Services LLC, a Prudential Financial company and member SIPC. Prudential Fixed Income is a unit of Prudential Investment Management, a registered investment adviser and Prudential Financial company. Prudential Investments, Prudential, the Prudential logo, Bring Your Challenges and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.

  Editor's Note 
  • This interview was originally published in the November 2012 issue of Financial Advisor Magazine
  • THIS IS A PAID PRODUCT ANNOUNCEMENT. Product announcements appearing in SmartBrief are paid advertisements and do not reflect actual SIFMA endorsements. The news reported in SmartBrief does not necessarily reflect the official position of SIFMA.

Product announcements appearing in SmartBrief are paid advertisements and do not reflect actual SIFMA endorsements. The news reported in SmartBrief does not necessarily reflect the official position of SIFMA.
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