Interest Rates
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.
Better days ahead for bonds?
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
Sources: Capital Group, Bloomberg, Bloomberg Index Services Ltd., RIMES, U.S. Federal Reserve.
Income is returning to fixed income
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.
Equities delivered returns in past rising rate environments
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
Sources: Capital Group, MSCI, Refinitiv Datastream, Standard & Poor's, U.S. Federal Reserve. S&P 500 and MSCI World returns represent annualized total returns for U.S. and global stocks, respectively.
Is the target date glide path actively managed?
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.
Fixing the glide path in fixed income: A hypothetical example
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
Source: Capital Group, hypothetical glide path illustration.
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?
Is the fixed income glide path managed flexibly?
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.
Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility.
These risks may be heightened in connection with investments in developing countries.
The value of fixed income securities may be affected by changing interest rates and changes in credit ratings of the securities.
The return of principal for bond funds and for funds with significant underlying bond holdings is not guaranteed. Fund shares are subject to the same interest rate, inflation and credit risks associated with the underlying bond holdings.
There may have been periods when the results lagged the index(es). The indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.
Bloomberg U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market.
MSCI World Index is a free float-adjusted market capitalization-weighted index designed to measure equity market results of developed markets.
S&P 500 is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks.
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
Each S&P Index ("Index") shown is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright ©2022 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part is prohibited without written permission of S&P Dow Jones Indices LLC.
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