More than thirty-six years ago, in early February 1982, the interest rate for 10-year U.S. Treasury bonds peaked at almost 15 percent.
While a double-digit interest rate on U.S. government bonds is difficult to imagine, especially in this era of historically low interest rates, that was the end of the last bear market in bonds, where rising bond rates resulted in lower yields.
For more than three decades, Americans have enjoyed a bull market in bonds. Investors in various types of bonds—from AAA-rated governments to lower-rated high yield issues—have benefitted as interest rates trended lower and values trended higher.
Now, it appears the United States may be at a turning point.
In February, Goldman Sachs’ Macro Chartbook reported, “The biggest change from our Outlook is the magnitude of the U.S. fiscal expansion at a time when the economy is pushing past full employment. This …increases the risk of overheating in the long term, as financial conditions remain easy despite monetary tightening.”
When the U.S. economy overheats, demand is higher than supply and prices often rise. Inflation pushes higher. The Federal Reserve is tasked with maintaining steady economic performance, and uses interest rates to cool the economy.
Pushing interest rates higher increases the cost of borrowing and often slows spending and growth. Since 2016, the Fed has raised rates six times, and it is expected to raise rates at least three more times during 2018.
The long bull market in bonds has persuaded some investors that bonds are a ‘safe’ asset class. There is no such thing. Every investment has risks. While it can be said that bonds generally offer less risk and lower return potential than stocks, that doesn’t mean bonds are safe investments.
As interest rates rise, the risks associated with bonds will become more apparent. While interest rate and economic cycles can be difficult to predict, it’s important for both plan sponsors and plan participants to understand the potential effects of rising interest rates.
Plan sponsors should review their investment policy statements and investment line-ups, paying attention to:
- The types of bond investments available through the plan,
- The reasons those investments are included in the plan, and
- The ways a rising interest rate environment may affect the investments by potentially reducing yield.
While reviewing plan-level exposure, make sure to document your process and findings, and make changes if they are needed. They may not be.
A potential rise in rates also makes it important for plan sponsors to review basic investment principles with plan participants.
One of the most important is risk management with a particular focus on inflation risk. Younger employees are often risk-averse, and most have begun their careers during a period of low inflation.
As a result, it’s important to help them understand how inflation erodes savings over time.
When the value of a participant’s savings and investments grows more slowly than inflation increases, purchasing power declines. One way to bring this idea home is to ask participants how much their grandparents paid for their first automobiles.
In 1950, the median car price was about $2,200. If prices increased with inflation, in 2018 the median new car price would have been $23,000. However, the price of new cars has risen faster than inflation. In early 2018, the average price of a new auto was $35,000.
Participants can protect against inflation risk by investing some of their savings in stocks, which historically have returned more than inflation (of course, past performance cannot guarantee future results).
Last year was an unusually tranquil period for financial markets. While the return to volatility is uncomfortable for many investors, it’s a more normal state of affairs. It also may create teachable moments for plan participants.
We appear to be nearing an economic inflection point. As bonds cycle into a new stage, it’s important for plan sponsors to review plan investment line-ups and determine whether and how rising interest rates may affect the plan and its participants. They should document their processes and decisions.
It also is a good time to remind participants that the recent period of calm wasn’t the norm for financial markets—a mountain chart of the Standard & Poor’s 500 index can help illustrate the point—and remind them of some basic investment principles.
Terry Dunne is senior vice president and managing director of Retirement Services at Millennium Trust Company, LLC. Mr. Dunne has over 35 years of extensive consulting experience in the financial services industry.
Millennium Trust Company performs the duties of a directed custodian, and as such does not sell investments or provide investment, legal or tax advice.