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. In 2012, Prudential Investments Mutual Funds 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 three-part blog series sponsored by Prudential, we will examine how fixed income can enhance retirement menus. This interview was originally published in the November 2012 issue of Financial Advisor magazine.

Jerilyn Klein Beir, a contributing editor for Financial Advisor magazine, held a roundtable discussion on the topic of fixed-income choices with participants including 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 Absolute Return Bond and Core Plus Fixed Income Strategies at Prudential Fixed Income.

In today’s Part 2, we will explore ways to construct better portfolios through the use of these plans.

In Part 1, which was published May 22, the experts explained 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.

Part 3 of the interview will explain how financial advisors can help in this effort.

The topic of helping participants construct better portfolios is an important one. When asked what types of fixed-income funds could potentially help in that effort, Tipp notes that “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.”

Instead, one of the middle grounds that could become more of a value generator is high yield bond funds. “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,” Tipp says. (Sources: Morningstar, Barclays Capital. Jan. 1, 1997 to June 30, 2012.)

Collins notes, “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.”

These types of 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,” Collins says.

If interest rates remain flat for a while, however, you can capture the yield with the 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,” Collins says.

Tipp notes that “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,” Tipp says.

When asked about the potential of high-yield bonds and global bonds, Tipps says, “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.”

The next installment of this blog series will be published next week and will examine the role of the financial advisor and how they can help in the effort with DC plans. Learn more from this video by Rosenberg. Additional information may be found in this white paper.

Mutual fund investing involves risk. Some mutual funds have more risk than others. The risks associated with investing in these funds include but are not limited to: high yield (“junk”) bonds, which are subject to greater market risks; foreign securities, which are subject to currency fluctuation and political uncertainty; and emerging markets, which are subject to greater volatility and price declines. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost, and it is possible to lose money. There is no guarantee a Fund’s objectives will be achieved. The risks associated with each fund are explained more fully in each fund’s respective prospectus. Fixed income investments are subject to interest rate risk, where their value will decline as interest rates rise. Diversification does not guarantee a profit or protect against a loss in declining markets.

Past performance is no guarantee of future results.

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.

Mutual funds are distributed by Prudential Investment Management Services LLC, a Prudential Financial company. 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.

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One Response to “Experts offer tips to construct a better portfolio”

  1. Great article! Offers a lot of insight and so many people really need to be reading this right now.