Now that Federal Reserve Chairwoman Janet Yellen has acknowledged that the central bank is likely to raise rates later this year, institutional investors are evaluating the role of fixed income in their portfolios.
Institutional investors on the whole have been reserved when it comes to their fixed-income allocations, said Bryon Willy, a principal at Mercer in Chicago.
But after 35 years in which bonds could be both a stabilizing force in portfolios and a source of return, fixed income isn't “the hedge that it historically has been,” he noted.
That change and uncertainty about exactly when and how quickly short-term and long-term rates will rise (and if they will move at the same pace) after policymakers act means there are several different responses being contemplated by asset owners and their managers. Spikes in long government bond yields in mid-2013 and earlier this year have shown what can happen quickly when changes come.
A number of money managers that Pensions & Investments spoke with said the Fed's decision earlier in September to stand pat on overnight rates, as well as Ms. Yellen's subsequent comments, have not made any significant change in institutional investors' appetite for fixed-income strategies. However, some have noticed investors gravitating toward strategies that aren't rate-sensitive, such as short-duration, unconstrained and strategic income strategies.
What rising rates will mean for institutional investors depends on the role fixed income plays in a portfolio, said Stephen M. Kane, group managing director and generalist portfolio manager in the U.S. fixed income group at TCW Group Inc., Los Angeles.
Robert C. Merton, 1997 Nobel laureate in economics and MIT Sloan School of Management distinguished professor of finance, cautioned that asset owners concerned with pension liabilities should be paying more attention to long-term, rather than short-term, rates.
“The long-term rate is the rate that matters. The implication is that if the Fed raises short rates, longer-term rates will probably go up,” said Mr. Merton. “But that doesn't necessarily mean that long-term rates will go up. They may, but they don't have to.”
For those investors that use fixed-income assets as a hedge, Mr. Kane said he believes large pension plans with a traditional 60-40 allocation plan (or something similar) shouldn't scramble to reallocate. In fact, it would make sense to keep their allocation as is.
Investors using fixed income as a source for absolute return might want to reallocate to cash before rates rise, he noted. Others hoping to generate income should shorten maturities so when rates rise, it would be easier and faster to reinvest. And those looking to implement liability-driven investing strategies should increase their allocation to fixed income as rates rise.
“It all depends on a lot of variables — including how much rates rise,” Mr. Kane said.
Other industry observers say that what happens with short-term rates might be a red herring, especially for long-term investors.
In a phone interview, Matthew Stroud, head of delegated portfolio management, Americas, at investment consulting firm Towers Watson & Co., New York, said it appeared to him that the Fed is setting up expectations for a rate increase in December, the first increase since June 2006.
“The market is currently digesting this information,” Mr. Stroud said about the telegraphed rate hike.