We've previously discussed differences in TDF underlying exposure to U.S. vs International Equity exposure. Continuing that theme, let’s shift gears and look at the fixed income side of the equation. While there are many factors that can differentiate fixed income portfolios, in this post we’ll focus on the metric of the underlying duration of the fixed income holdings.
By Clayton Fresk on March 24, 2020
In a previous post, we discussed differences in TDF underlying exposure to U.S. vs International Equity exposure. Continuing that theme, let’s shift gears and look at the fixed income side of the equation. While there are many factors that can differentiate fixed income portfolios, in this post we’ll focus on the metric of the underlying duration of the fixed income holdings.
Very simply, duration measures bond’s sensitivity to changes in interest rates. While more nuanced than this, a simple example commonly shown is for a bond with a 5-year duration, it can expect to decline in price by 5% for every 1% increase in interest rates. Or conversely said given this recent rate move we’ve seen, increase by 5% for every 1% decrease in interest rates.
Duration is a good starting point for measuring fixed income differentials, as no matter what fixed income subclass a TDF may hold (treasuries, corporates, etc.) measuring duration can lend itself to an apples-to-apples comparison. There are other factors that can differentiate as well (spread exposure, inflation-protection, etc.), but for now we’ll start looking at duration only.
For this analysis, we looked at the underlying fixed income fund holdings of the TDF and analyzed the average duration of the individual underlying fund. We then common-sized it back to measure the duration of the fixed income portfolio as a standalone.
Here is a chart of the TDF industry by vintage on the horizontal and the duration on the vertical.
Chart Source: Stadion
A couple points we can glean from the data:
- There is a relatively large dispersion in the duration exposures, with the dispersion more pronounced in vintages farther from retirement. The range runs from about 0.5 years all the way up to 18 years in the 2060 vintage.
- This range generally tightens (outside a few outliers in the 2030-2020 vintages) moving towards retirement
- The average duration within the industry ranges from about 4 to 6 years, and this average shortens (decreases) in the vintages nearer retirement
- Whereas the industry average duration shortens/decreases along the glidepath, the S&P Target Date index actually lengthens/increases
- This appears to be a case where due to index methodology, certain fixed income asset classes (high yield, TIPS) are not held in the longer dated vintages and are replaced with cash, hence shortening duration in said vintages.
Like what we saw in the U.S./INTL split on our equity analysis, TDF managers can either hold the same fixed income portfolio across all vintages (linear allocation) or alter the portfolio as the vintages near retirement. When digging into fixed income portfolios, TDF managers, more often than not, do not have a linear allocation and would rather alter the allocation near retirement, most commonly with the addition of TIPS (Treasury Inflation Protected Securities) securities in the middle of the glidepath. Managers also regularly add shorter-duration holdings and/or cash in vintages nearer retirement. We’ll touch more on this when we delve into fixed income holding differentials, in later posts.
What we can look at is the standard deviation of the durations across the glidepath to determine the linearity of the fixed income allocations in terms of duration. Here is a scatter of the average duration across the vintages and the standard deviation of the durations.
Chart Source: Stadion
The average and S&P both have roughly a 0.5 standard deviation. So, anything to the left of these dots on the scatter have a more linear/static duration allocation. Many of these more static allocations are also in the 4-6-year range. While there are averages that have lower durations, what is seemingly more interesting are those with longer duration profiles, some of which are greater than 10 years. What is also interesting is that a couple of these have a relatively static allocation (low standard deviation), while a couple have a very different allocation along the glidepath (high standard deviation).
So, what does this all mean? Having a shorter or longer duration profile does not make a TDF series better or worse. It’s just a matter of whether the exposure aligns with the preferences of the plan sponsor/participants. And it’s a matter of education and knowledge of where the selected plan TDF stands in its duration exposure.
Author: Clayton FreskClayton Fresk joined Stadion Money Management in 2009 and currently serves as Portfolio Manager of Stadion’s Retirement investment strategies, which comprises oversight of Stadion’s managed account, target-date, and risk-based strategies. He provides thought leadership for Stadion’s participant level, customized retirement solutions, in order to ensure that its glide path technology and asset allocation are able to support all intermediaries in the defined contribution ecosystem. Clayton holds the Chartered Financial Analyst designation and is a member of the CFA Institute and the CFA Society of Minnesota. He also received an MBA degree and a Bachelor's degree in Finance & Marketing from the University of Minnesota.
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