The decades-long decline in interest rates is over, and 2018 will be remembered as the year when the trend reversed and rates began to move consistently higher. Well, maybe.
Market observers have been making that call confidently for several years and the 10-year Treasury remains well below 3 percent.
But the case for higher rates make sense. The Fed has announced its plan to increase rates and reduce its bond inventory. Economic growth looks better than it has in recent years. If you agree that there is a reasonable chance of higher rates in the near future, should you be discussing that scenario with your plan sponsors? And what, if any, advice should you consider giving them about their plan lineups in light of that forecast?
Review the Options
Brendan McCarthy, managing director and national sales manager for DCIO with Nuveen in Boston, Massachusetts, believes consultants should review the rising rates scenario with their plan sponsor clients because of the move’s potential impact. He notes that a 1 percent increase in rates results in a 6 percent drop in the Barclays Capital U.S. Aggregate Bond Index. The discussion should review both a plan’s funds lineup and the potential impact of higher rates on the sponsor’s target date fund selection, he maintains. “That plan sponsor should be periodically reviewing the investments in the plan, assessing the market environment and making changes as necessary,” he says.
Target date funds account for a growing percentage of plan assets, so consultants should review several of those funds’ features, McCarthy suggests. In terms of a plan’s fixed income allocation, consultants can consider the potential benefit of adding an option that might diversify away some of the interest rate risk exposure. One possible consideration could be adding an actively managed bond fund to supplement passive, index-tracking funds because active funds have greater ability to diversify across different fixed income sectors, he explains. A second consideration is the glide path that the plan’s target date funds follow. “A higher glide path allocation to equities in a rising rate environment can offer the ability for stronger performance and it can also help address longevity risk,” he says. The third factor to consider is whether the target date fund has a tactical component that allows the manager to respond to changing market environments, he adds.
Stay the Course
Consultants should keep clients informed about what’s happening in the capital markets, but there is a need for caution against overreacting to possible rate increases, according to Christopher Philips, CFA, head of Vanguard Institutional Advisory Services in Malvern, Pennsylvania. “We want to make sure that everyone’s aware of what’s happening in the markets but we don’t expect them to act on it because we just don’t know what the future holds,” says Philips.
The difficulty of predicting if, when and how rate increases might unfold and their potential impact underlies Philips’ comments. Vanguard’s research consistently finds that accurate rate forecasting is difficult. “All you have to do is look at the last eight years when every market strategist that you would have read would have been predicting higher rates and interest rates have remained steady this entire period,” Philips observes. “The challenge with predicting rates is that the Federal Reserve controls the Fed’s fund rate and effectively short-term money market rates. Everything beyond that is dictated by the market participants that are involved with setting prices and a lot of it is based on inflationary expectations.”
Predicting rates’ direction is just the first step, says Philips: “You need to get inflation expectations correct, you need to get credit spreads and their trajectory or direction of credit spreads correct. You need to get the actual level of interest rates correct and, then, you need to pick bonds that are benefiting from all of those different scenarios and that’s a very, very tall order to do in a cost-effective manner.” The result, he adds, is that on average upward of 80 percent of actively managed funds underperform their risk-adjusted benchmark in the marketplace.
Vanguard’s research also makes the case that bond bear markets are less severe than those for equities. Since 1980, the largest calendar-year loss for the Barclays U.S. Aggregate Bond Index was -2.9 percent in 1994. The various bond classes will react to higher rates differently, of course, and a diversified fixed income allocation within the target date fund is a sound strategy. But history indicates that most investors should not view a potential bond bear market with the same apprehension as a potential equity market, according to Vanguard. Instead, staying the course and not overreacting to potential or actual rate increases has been the prudent strategy.