Interest rates are on the rise, and that is bad news for fixed-income investors. The yield on 10-year Treasury notes rose from 1.6% in early May to 2.9% in early September before receding to around 2.5% in mid-October. Because retirement plans have relied on fixed income to keep the volatility of the portfolio down, the expectation of a continued rise in interest rates creates a problem. One potential solution is to look at adding alternative investments to the portfolio mix. Adding alternatives might not only help to reduce risk in the portfolio but also it might offer employers an opportunity to educate employees, which might result in higher participation rates.
As interest rates are on the rise from historic lows and with the expectation they will continue to move upward toward a more “normal” level as the economy improves, fixed-income investments are facing a major headwind. Not only is it likely future bond returns will be muted, but their volatility might increase given that fixed-income duration is longer when interest rates are lower (longer duration equates to more volatility as rates rise).
Fixed-income investments have been a staple of retirement plans since they were introduced decades ago. Not only did fixed-income provide relatively steady income to a diversified portfolio, but it also produced capital gains over most time periods, adding to the investment's total return. Much of the total return from AAA corporate bonds over the past 30 years was due to interest rates having declined from a high of around 15% in 1982 to a low of less than 4% at the beginning of 2013. In addition to providing solid returns in a diversified portfolio, bonds helped to offset some of the volatility investors experienced when investing in equities. To that end, bonds acted as a hedge to overall portfolio volatility.
So with the stage set, we believe the inclusion of alternative investments within defined contribution plans can offset some of this impending headwind for plan participants. Alternatives such as commodities, master limited partnerships, bank loans and hedge funds have provided good risk-adjusted returns over time. One of the great benefits of many alternative investments is they tend to have lower correlations to traditional fixed income and equity investments, and thus can lower the overall volatility or riskiness of a portfolio. Below is a table of correlations between the traditional stock and bond asset classes and various alternative asset classes.