Fixed Income is one of five broad asset classes in PERA’s investment portfolio and represents about a quarter of PERA’s $45 billion portfolio. This asset class plays a critical role in the overall asset allocation by serving adding diversification to PERA’s portfolio, acting as a stabilizing anchor during turbulent times in the stock market and a balance against other asset classes like equities. The investment returns from fixed income have been favorable historically and help meet PERA’s investment objectives.
What is Fixed Income?
Fixed Income investments are various types of bonds. A bond is very much like a loan issued by a bank. A bond issuer receives money from a bond purchaser and agrees to repay the bond at a specified interest rate on a fixed schedule, hence the name: fixed income. The benefit of this type of investment to a bond purchaser, or investor, is that the rate of return and the timing of repayment are generally known at the time of investment. Unless the borrower defaults and fails to make payments, the income will flow in on a set schedule. This certainty is offset by the fact that the issuer is not obligated to pay back any more than the amount specified in the bond.
Types of bonds
Bonds come in various types. Some, like U.S. Treasury bonds, are backed by the full faith and credit of the U.S. Government. Bonds issued by corporations are backed by a repayment pledge, giving the bond holder a lien on the assets of the corporation. If the corporation defaults on the bonds, the bondholders have claims on the corporation’s assets ahead of its stockholders. Other similar investments include securitized loans that have claims on pools of assets like mortgage loans, auto loans, credit cards, and bank loans. By pooling assets such as mortgages into securitized bundles, the loans spread the risk of defaults across a large number of smaller loans and become economical in size for pension funds and other institutional investors to buy.
Quality of bonds
Bonds also come in various credit qualities and their yield is proportional to their risk. U.S. Treasury bonds are considered the highest quality and are most likely to be repaid on a full and timely basis. These bonds are rated AAA by credit rating agencies. Securitized mortgage-backed securities are also generally rated AAA. AAA bonds have the lowest risk and offer lower yields. The lower the rating in credit quality, the more bonds tend to compensate investors for taking higher credit risk with higher yields. Corporate bonds cover the full rating spectrum. Investment-grade corporate bonds are rated between AAA and BBB. High-yield corporate bonds, or what some refer to as junk bonds, go from BB to C.
Term of bonds
Bonds are also issued for various terms or maturities. Longer term bonds typically have a higher yield because the investment is tied up for a longer period of time. Just like all of the other asset classes, bonds have unique characteristics that affect the value of the investment. The PERA Fixed Income team takes into consideration these characteristics when managing the investment portfolio.
PERA’s fixed income portfolio is benchmarked against the Bloomberg Barclays U.S. Universal Bond Index. This is a broad-based index including a representative sample of the universe of investment-grade, high-yield, and emerging market bonds issued in the United States. The index is weighted by capitalization, meaning that each bond is weighted relative to its size. The benchmark provides a baseline for comparing PERA’s investment performance against the investable fixed-income universe.
The size of PERA’s Fixed Income allocation in the investment portfolio is guided by PERA’s Board of Trustees with advice from their independent investment consultant and PERA staff. This is set forth in the Board’s Statement of Investment Policy. Currently, the Fixed Income allocation target is 23.5 percent of the total portfolio with a range between 18 percent and 28 percent of total assets. According to a recent national survey, this is comparable to most U.S. public pension funds. PERA manages roughly 75 percent of the Fixed Income portfolio internally, providing significant cost savings for PERA members.
In November of 2008, the Federal Reserve, or “The Fed,” under Chairman Ben Bernanke initiated an unconventional monetary policy of quantitative easing to help restart the economy after the great recession. To implement this monetary policy, the Fed engaged in open market purchases of U.S. Treasury and mortgaged backed securities; both are fixed income securities. The Fed grew its balance sheet portfolio from $900 million prior to the recession to $4.5 trillion today through purchases of $3.5 trillion in bonds. This step in aggressive monetary expansion probably saved the U.S. economy from a severe recession, but the longer term consequences are still unknown. The Fed stopped expanding its balance sheet in October 2014, but continues to reinvest maturities and principle payments into U.S. Treasury and mortgage-backed securities in order to keep its portfolio size stable. Currently the Fed Governors are reviewing plans on how to unwind their balance sheet. Among investors there is widespread speculation on how the fixed income market will react once the Fed discontinues reinvestment of maturing securities and perhaps initiates outright sales.
Monetary policy and fixed income markets
The almost decade-long period of artificially low interest rates has been called by some a financial repression. The very low rates available to savers have reduced the income of retirees who expect to live off their investment income. For pension funds this is an almost universal problem with a 2013 OECD report highlighting how low interest rates reduce the expected rate of return on pension assets and may push investment managers to take on larger risks in a search for yield. The Fed’s low rate policy has constrained pension funds and forced institutional investors to seek alternatives that come with additional risks, costs, complexity, and may be less liquid than traditional fixed income.
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