As rates rise, investors scramble to lock in gains

The Board of Governors of the Federal Reserve System raised the federal funds rate on March 16, the second 25-basis-point increase in three months, and expects a number of similar increases through 2018 (see Figure 1). This confirms a long-anticipated theme: interest rates are on the rise.

Despite expectations of this message, investors had been far more focused on finding greater yield than hedging against rising rates. Since the November elections, however, views of U.S. tax and regulatory reform spurring economic growth have coincided with a growing concern about the effect of rising rates. Interest in taking gains before they disappear is growing, and shorter-duration or floating-rate products, such as collateralized loan obligations, have drawn increasing interest.

Corporate defined benefit plan sponsors have been desperate for higher yields, particularly at the longer end of the curve, as pension obligations are very long-dated. Obligations have about a 14-year duration, which means that a 1 percentage point decline in interest rates increases the value of the liabilities about 14%. Over the past 10 years, the 30-year Treasury yield has fallen almost 2 percentage points (to 3% from nearly 5% — see Figure 2), considerably increasing corporate DB liabilities. While the recent Fed action might help increase short-term rates, economic growth and inflation are often the main drivers for higher yields on longer-term bonds. Plan executives who had hoped for a rise in longer-dated rates but did not invest in matched assets (i.e., longer-dated bonds) have seen their plans suffer lower funding levels, often requiring them to divert cash to their plans that could have been reinvested in operations or distributed to shareholders.

It has been more than 10 years since we've had an environment of rising rates, and much has changed in that time. Insurers' portfolios now are generally more diversified into a broader array of asset classes, particularly among larger firms. Insurers are carrying fewer assets leveraged to interest-rate changes (such as special investment vehicles, subprime asset-backed securities and other highly volatile structured products). Also, since rates have been at historically low levels, insurers' current debt service is lower. Meanwhile, many pension plan sponsors and their advisers have attempted to derisk their portfolios. Working with experienced asset managers, these sponsors have adopted asset-allocation strategies to better match their liabilities, a process known as liability-driven investing. Rising long-term interest rates can lower the value of plan liabilities and thereby improve plan funding status, and an LDI strategy can help protect and maintain funding status in adverse market conditions.

Some plans are also applying interest-rate triggers to their derisking.

For example, a sponsor might see the 30-year Treasury reaching 3.5% as a time to shift a segment of the plan's growth assets into matching long-dated bonds, hedging a portion of plan liabilities from a potential interest-rate decrease. Even though we anticipate interest rates going up, sponsors are developing a greater appreciation for protecting the downside during unforeseen events.

One reminder of the last decade is that investors need to be prepared for unforeseen changes in market conditions. Insurers' portfolios are structured to support obligations to policyholders, and unforeseen events can wreak havoc on underprepared portfolios. An insurer that must pay out more than anticipated may be forced to liquidate holdings under adverse conditions — a sure destroyer of value. A robust discipline that matches a portfolio with the liabilities it supports is the best way to avoid this and maintain adequate liquidity.

Pension plan executives should heed the same message. The coming months may present opportunities to reach funding-level or interest-rate triggers, allowing plans to reduce their growth assets in exchange for longer-dated fixed-income assets. Sponsors should stay the course and not veer from their derisking programs based on a feel about the market, as these scenarios can be short-lived. Staying disciplined will remove human judgment from the equation and help plans incrementally take risk off the table as interest rates rise and funding levels improve.

Additionally, as plans derisk, more sponsors will be buying long-dated high-quality bonds and Treasuries, likely raising demand for long-dated credit, and increasing its price and reducing yield. Sponsors need to be careful to avoid overpaying for the risk.

A prominent view of the market environment today is that tax and regulatory reform will spur enough growth to support a rise in inflation and interest rates. Among the risks we see is the pace of reform will be slower than anticipated, and any benefit from tax and regulatory reform could be offset by adverse trade policy.

In our view, the best hedge is a diversified portfolio based on sound fundamental analysis, structured according to a robust plan that matches assets with the liabilities they support.

Owais Rana is managing director, based in New York, and Rich Sega is chief investment officer of Conning, Hartford, Conn. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.