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, a Cammack Retirement Insights article notes.
“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,” says Tracey M. Manzi, vice president, investments at Cammack Retirement, and the article’s author.
Manzi notes that investors tend to be concerned when interest rates rise, as the market value of their bond investment will generally decline. However, she points out that while the initial price impact may deliver a negative return over shorter periods of time, bond investors are generally better off when rates rise because 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,” she says.
Manzi also explains that duration 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. 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.
The three main drivers of bond prices are: inflation, interest rates, and the financial health of the issuer, she says. Retirement plan sponsors can capture a company’s financial health by trends in their credit rating and bond spreads.
“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,” Manzi states. She explains that 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,” she says.
Manzi points out 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.
Capital preservation strategies held in defined contribution (DC) retirement plans typically consist of a money market, short-term bond or stable value fund. 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,” the article says.
Likewise, short-term bond funds’ 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.
Stable value funds 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 accomplished through a 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.
Most retirement plan investment menus include an actively managed fund and a bond index option in the intermediate bond category, Manzi notes. Since bond index funds have high concentrations of government debt, they typically exhibit greater interest rate sensitivity than actively managed bond strategies.
“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,” the article explains.
In the current low interest rate environment, plan sponsors have increasingly offered a wider range of fixed income options to their participants, according to Manzi, with typically popular options being 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,” she explains
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,” Manzi says.
Treasury inflation protection securities (TIPS) offer built-in inflation protection because their principal and coupon will adjust upwards or downwards with the published inflation rate. But, Manzi warns, while TIPS are designed to guard against inflation, the asset class carries significant interest rate risk. She further explains that 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.“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,” Manzi concludes.