Janet L. Yellen, chairwoman of the board of governors of the Federal Reserve System, in a speech Sept. 24 declared her expectation the Federal Open Market Committee will raise interest rates before the end the year. An increase would put the Federal Reserve's monetary policy into new territory, not seen in almost 10 years since the Fed began to push down interest rates in an effort to stimulate the economy. It also will put most asset owner fiduciaries and institutional investments managers into a landscape they haven't experienced.
Interest rates pretty much have fallen steadily for 34 years, the working lives of most institutional investors, with only relatively brief periods of increases, creating a bullish market for bonds.
Careers have been built on more than three decades of generally falling rates. Institutional investors have structured their fixed-income strategies on that experience. An increase in the fed funds rate is no black swan event, catching institutional investors by surprise. Investors have had plenty of warning. Asset owner fiduciaries and other institutional investors should already be addressing the challenge a rate increase will mean, especially if it is only the first of many.
Rising rates could be ruthless on the value of bond portfolios. Asset owners, through diversifying asset allocation and tactical strategies, already should be preparing for the impact rising rates could have on the value of their portfolios.
The FOMC has kept the fed funds rate in a range of between zero and 0.25% since it first lowered the rate to that range in December 2008 to provide liquidity to the market during the financial crisis. Its move then was the first time it lowered the rate under 1%. The rate has been kept there for almost seven years — the longest period, at least in modern times, the rate has remained at any level. The last time the FOMC raised the fed funds rate was June 29, 2006, when it went to 5.25% from 5%.
A rate rise challenges liability-driven investing and risk-parity strategies, as well as asset owners hesitant about implementing LDI because low rates have made fixed-income instruments expensive. For them, triggering implementation is a question of timing the market. Academic research shows market timing strategies generally don't perform well.
Fixed income, long sought as a safe haven, has been a powerful return generator for more than a generation of institutional investors. Since the beginning of 1982 through the end of 2014, the total return on long-term government bonds has been an annualized 10.4%, while the total return on the S&P 500 in the same time frame has been an annualized 11.8%, according to the “Ibbotson SBBI Classic 2015 Yearbook,” produced by Ibbotson Associates Inc., a unit of Morningstar Inc.
The environment of low yields in recent years has helped drive some asset owners away from a once dependable safe haven to diversify into alternative asset classes. How well greater diversification will pay off is something asset owners cannot just wait to play out. They have to allocate their portfolios to better manage risk and opportunities.