The end of a 40-year period of declining interest rates has participants taking a closer look at their retirement goals and asking if they’re still on course to reach them. Whether an investment menu is due for a mid-course evaluation or adjustment, one of the first places to look is the fixed income allocation, where the impact of a rate hike is felt most acutely.
In the first half of 2022, the core fixed income benchmark, the Bloomberg U.S. Aggregate Index, was down more than 10%, the worst period in almost 50 years. As inflation hit 40-year highs, the Federal Reserve (Fed) raised its key interest rate target in a series of unusually large increases. Overall, the increase was so quick and unexpected that, according to our midyear bond outlook, much of the Fed’s moves may already have been priced in.
There are reasons for optimism, though. History suggests that better days for bonds follow large rate increases. In fact, since 1977, the additional yield resulted in average total returns of 13.2% the first year after the hike and 12.8% the second year.
Bonds historically have weathered rate hikes
A bond’s total return is the function of price changes and yield, or the interest paid to the bondholder. As interest rates rise, the painful losses of early 2022 may lay the groundwork for future income produced by rising yields. Rising rates can reveal new income opportunities across bond markets, which is important to participants near or in retirement.
History shows equity returns could be looking up as well. During eight rate-hiking periods since 1977, the S&P 500 posted an average annualized return of 12.7%. Meanwhile, on a global basis, stocks delivered a 12.1% average annualized return during the same period, as tracked by the MSCI World Index.
Equity returns during rising interest rate environments
As rates rise, the flexibility afforded by active management allows fixed income and equity portfolios to shift in thoughtful response to what could be paradigm shifts in the availability of credit. Particularly, a target date fund (TDF) manager may find it appropriate to vary the funds’ asset mix and even the glide path allocations to better prepare participants for this changed environment.
Increased exposure to income-focused equity could serve as an inflation buffer during a rising rate environment. After nearly a decade of near-zero rates, it’s not just fixed income but dividend income that may see a meaningful increase in the coming years. Increasing dividend payouts can be seen as a signal of management’s confidence in future earnings growth. One hypothetical interactive chart from Capital Group suggests that past earnings growth may signify solid future return potential for investors.
Long-term bonds tend to be the most sensitive to dramatic rate hikes due to the increased potential for unforeseen changes in rates over time and, by implication, the bonds’ value. Accordingly, one way a target date series may respond is by adjusting the duration of the bonds held in the overall portfolios. Some active managers may opt to increase duration — extend the average length of the bond before maturity — in anticipation of rates stabilizing and, perhaps, going lower.
As shown here, such a strategy would result in a significant increase in the role of income as a component of that target date series’ return, and capital preservation ultimately would play a narrower role.
Glide path adjustments could increase the role of income-oriented funds
Active managers with a robust set of investment tools may elect to increase exposure to commodity-related or inflation-protection securities to provide an additional inflation defense — often without changing the overall glide path.
At Capital Group, we believe fixed income should serve four key roles in a portfolio. How well do your clients’ portfolios meet them?
Are your clients’ TDFs flexible enough to manage inflation risk? That’s today’s relevant question, especially for older participants near or in distribution. Year-end 2022 plan reviews may wish to shine a light on how their existing portfolios have been repositioned.
Tell your clients how their target date funds are adapting to market conditions. Help them understand how TDFs may adjust to rising interest rates, which gives you an opportunity to demonstrate your value.
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