What Retirement Plan Sponsors Need to Know about Rising Interest Rates
Interest rates have continued to climb in 2018, with the yield on the 10-year Treasury benchmark note edging above the 3.0% level for the first time since 2014. Even more notable has been the rise in the two-year rates, which topped 2.5% in recent weeks. With the Federal Reserve poised to raise interest rates further, plan sponsors may be wondering how recent market movements are impacting the fixed income investment options in their retirement plans.
While the cyclical shift in rates may be unnerving, particularly as the Federal Reserve has stepped up its pace of interest rate increases over the last year, there is no need to panic. While the rising rate environment will certainly create a headwind for various fixed income investments, it does not mean that all bond strategies in a retirement plan will produce negative returns. Before we address how various fixed income investments have been impacted by rising rates, we will begin with some key bond concepts plan sponsors should understand.
Basic Bond Concepts
One of the basic tenets of bond investing is that prices move in the opposite direction of interest rates. Therefore, investors tend to be concerned when interest rates rise, as the market value of their bond investment will generally decline. While the initial price impact may deliver a negative return over shorter periods of time, bond investors are generally better off when rates rise. On the surface this may seem counter-intuitive; however, higher yields will generate greater income which can then be reinvested at more favorable interest rates. This cycle of compounding interest at higher rates typically offsets the initial price decline from rising rates.
Another key concept to understand is duration. Duration, otherwise known as interest rate risk, estimates how a bond’s price will be impacted by changes in interest rates. Generally, the longer a bond’s duration, the more its value will fall as interest rates rise. Let’s look at a simple example to illustrate this concept. If interest rates rise by 100 basis points (1.0%), the price of a bond with a two-year duration will decrease by 2.0%, and the price of a bond with a twelve-year duration with decrease by 12.0%. This works the same way when interest rates fall. In a falling interest rate environment, the value of a bond with a longer duration would rise by more than the value of a bond with a shorter duration.
It is also important to know that bond prices are highly sensitive to credit risk. Credit risk, also known as default risk, is the risk that a bond issuer will default on their payments of interest and principal to the bond holder. To compensate for taking this risk, corporate bonds entice investors with higher yields than comparable U.S. Treasuries. Various credit rating agencies, such as Moody’s or Standard & Poor’s, assign credit ratings to individual bonds. Bonds that are less likely to default are given higher ratings, while bonds that are more likely to default are given lower ratings. Bonds with the lowest credit rating or the highest credit risk tend to offer the highest yields, whereas bonds with the highest credit rating or lowest credit risk tend to offer lower yields.
The two key components of a bond’s total return come from its income (also known as yield) and any change in its price over time. The three main drivers of bond prices are: inflation, interest rates, and the financial health of the issuer. A company’s financial health is typically captured by trends in their credit rating and bond spreads. The income component is also a very important driver of returns. Historically, the majority of a bond’s total return comes from the income it generates.
Bonds’ Role in Asset Allocation Decisions
High-quality bonds have traditionally been considered the safe haven investment in asset allocation decisions. This remains true regardless of the level of yields or the current market environment. While, in recent years, the fixed income landscape has become considerably more challenging for managers to navigate, it does not diminish the role bonds should play in any asset allocation model.
Bonds are meant to serve four primary functions in a diversified portfolio: capital preservation, income, inflation protection, and diversificaton from equities. While the optimal allocation to bonds and within the sub-asset classes can vary greatly depending on an investor’s risk tolerance and time horizon, bonds will continue to perform these critical functions in any type of market environment.
The Impact of the Rising Rate Environment on Fixed Income Investments in Defined Contribution (DC) Plans
While rising interest rates typically lead to lower bond prices, it is important to remember that rate increases do not impact all bonds in the same manner. Some sectors of the bond market will do well in a rising rate environment. Below, we review how various fixed income asset classes, concentrating on those typically used in a DC retirement plans, respond as rates rise.
Capital preservation strategies held in DC retirement plans typically consist of a money market, short-term bond or stable value fund. These conservative investment options are appealing to risk-averse investors, such as those nearing or in retirement, as they provide a low-volatility, low-risk investment that aims to preserve capital.
Money market funds have the least interest rate risk as they invest in securities with a duration less than one year. This asset class tends to be the most sensitive to changes in the Fed’s policy rate. As such, rising interest rates bode well for money market funds as the higher rate environment brings a much-needed boost to their yields. This is welcome news for safety-conscious investors who have been starved for yield after a decade of earning near zero on their cash investments. With the economy doing well and the Federal Reserve signaling that further rate hikes are on the horizon, money market yields will likely continue to climb.
Short-term bond funds generally invest in securities that mature in one to three years. The limited time to maturity means they are less sensitive to rising interest rates, so the fund’s value will not decline as much as other fixed income options when interest rates rise. While this asset class is traditionally used as a higher-yielding alternative to a money market, the term “short term” does not necessarily mean a fund has low risk. Some short-term bond funds carry extensive credit risk, which can lead to significant losses during turbulent market environments. This was most evident during the financial crisis, where some credit-focused short-term bond funds were down over 10%.
Stable value funds, a staple in DC retirement plans, are designed to offer returns commensurate with other high quality short-to-intermediate term bonds, combined with insurance protection to insulate investors from interest rate fluctuations. This protection is intended to “smooth” or make the fund’s returns more consistent over time, which is accomplished through the crediting rate mechanism. While the prospect for higher interest rates may lead to lower market-to-book values, over time, the crediting rate should begin to rise. Rising crediting rates bode well for safety-conscious investors.
Intermediate or Core Bond
Most retirement plan investment menus include an actively managed fund and a bond index option in the intermediate bond category. This asset class provides broad exposure to the high-quality sectors of the bond market, most notably the U.S. government, securitized debt, and investment-grade corporates. Intermediate or core bonds generally serve as the anchor in any asset allocation mix, providing income greater than cash while simultaneously acting as a buffer against equity market sell-offs.
Passively managed core bond funds appeal to the fee-conscious investor and are designed to mirror the composition and performance of a benchmark index, such as the Bloomberg Barclays U.S. Aggregate Index. Since bond index funds have high concentrations of government debt, they typically exhibit greater interest rate sensitivity than actively managed bond strategies. Bond index funds also only invest in high-quality or investment grade debt, so they tend to have less credit risk than an active manager. These differentiators can work to their advantage during periods of declining interest rates and market meltdowns. However, they can also restrain relative performance when interest rates rise, and credit fundamentals are steady or improving.
Actively managed core bond fund strategies look for opportunities to outperform their index. While the nature of how they do this varies greatly from manager to manager, typical approaches used involve the ability to invest in out-of-benchmark sectors, such as non-U.S. developed, high yield and emerging markets, as well as opportunistic sector rotation, duration management flexibility and investing in foreign currencies. These added dimensions of risk, with proper risk controls, should allow active managers to perform better in almost any interest-rate or credit environment. While some active managers who had extensive credit risk in their portfolios performed poorly in the 2008 downturn, the performance drag they experienced was short-lived.
Diversifying Fixed Income
In the current low interest rate environment, plan sponsors have increasingly offered a wider range of fixed income options to their participants. Popular options typically consist of a high yield, world bond, emerging market, or a multi-sector bond fund. These strategies are intended to complement the traditional core bond option by providing higher income and protection from rising rates.
These higher-yielding fixed income sectors tend to have lower duration or interest rate risk and will generally outperform a core bond strategy when interest rates are rising, providing credit conditions and economic growth remain favorable. This is because the income component cushions the negative impact from the rate increases. Since these asset classes have considerable credit risk, they can underperform significantly when fundamentals are deteriorating. For example, according to Morningstar, the average high yield bond manager was down over 25.0% in 2008. While the average manager’s performance rebounded strongly in 2009, this level of volatility can be unnerving for some investors. That is why a modest allocation is typically recommended.
World bond strategies offer diversification from U.S. rates and the potential for enhanced returns. With U.S. rates climbing, an allocation to foreign bonds can offer investors shelter from the recent price declines in Treasuries and other U.S. fixed income assets. This is largely because other economies may be following a different rate path than the U.S. and rates may be stable or falling based on their local market developments. While the nuances of international fixed income investing are beyond the scope of this article, it is worth mentioning there are other risks to consider when investing overseas.
Treasury inflation protection securities (TIPS) provide a hedge against inflation and diversification from equities. TIPS offer built-in inflation protection because their principal and coupon will adjust upwards or downwards with the published inflation rate. While TIPS are designed to guard against inflation, the asset class carries significant interest rate risk. These two critical factors can lead to different outcomes depending on the market environment. For example, if interest rates are rising and inflation is accelerating, TIPS should outperform conventional Treasuries. However, if rates are rising and inflation declines or remains constant, TIPS strategies may perform poorly due to their extended duration profile.
What Should Plan Sponsors Be Doing?
With interest rates on the rise, it is important for plan sponsors to make sure their investment lineup offers the necessary asset classes for participants to build a diversified portfolio. This extends not only to the plan’s equity investments, but also to the fixed income options. By providing a more diversified set of fixed income options, plan sponsors can help participants be better equipped to weather any challenging market environment, such as the rising rate environment we are in right now.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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