How do rising rates impact investors—and unique considerations for defined benefit pension plans?
With the U.S. Federal Reserve (Fed) officially kicking off the start of the rate-hiking cycle with a 25-basis-point increase last week, the selloff in bond markets continues, with the yield on the benchmark 10-year Treasury note now around 2.4%—versus 1.5% at the end of December. The first quarter of 2022 has been mostly characterized by rising yields, with the upward climb interrupted only by the Russian invasion of Ukraine on Feb. 24, which sparked a flight-to-safety reaction in late February and early March. Since then, however, the selloff in bonds largely resumed as markets shifted their focus toward policy tightening. This has led many institutional investors to question just how high terminal rates could climb during the current cycle—and whether or not changes to investment strategies may be warranted.
To answer these questions and to help address common investor concerns, we sat down with Kevin Turner, our managing director and head of investment strategy and solutions, and Van Luu, our director and head of currency and proprietary strategies. Below is a summary of our conversation, with answers edited for length and clarity.
Q: Let’s start with the Fed. We saw the first rate hike since 2018 last week, with the central bank indicating several more rate hikes are in the works. What level could borrowing costs eventually rise to?
Van Luu: The Fed could increase its cash rate to what’s known as the neutral or equilibrium rate, or r-star, over time. This is generally thought of as the rate that will allow the economy to grow at its potential and keep inflation in-line with the central’s bank’s target. In other words, the equilibrium rate is the point at which economic policy is considered neither restrictive nor accommodative.
It’s important to note that the equilibrium rate is unobservable and very difficult to estimate precisely in real time. That said, our research, which takes into account the average of several different models that predict r-star, suggests this rate is probably around 2.25%. So, our best estimate is the Fed will ultimately lift rates to 2.25%, give or take, during this cycle.
Q: 2.25% seems on the low side, compared to where previous rate-hiking cycles ended. Am I correct in this thinking?
Van Luu: Mostly, yes. Prior to the Great Financial Crisis (GFC), the federal funds rate generally peaked slightly north of 5%, like in the mid-1990s and the mid-2000s.1 Notably, however, the cash rate only rose to around 2.5% during the last-rate hiking cycle , which occurred from 2015-2019. We think this rate-hiking cycle is likely to peak in a similar fashion as that one.
Q: What factors, in your opinion, have caused the equilibrium rate to drift lower in the post-GFC era?
Van Luu: Shifting demographics are likely playing a key role. As the U.S. population ages, we’re seeing more and more baby boomers retire—and retirees generally prefer to hold more bonds in their portfolios. This has led to a structural increase in the demand for risk-free assets, which is helping push down the equilibrium rate.
Another likely factor is the global savings glut. In the wake of the GFC, household savings have increased worldwide, and we’ve also seen companies rein in their capital expenditures. Both of these factors generally lead to less demand for investment projects, which in turn leads to lower rates (in order to incentivize more companies to borrow money). Think of the yield on government bonds as a key barometer of supply and demand for capital. The lower it is, the less demand there is for capital—and the greater the savings supply.
Q: How does the equilibrium rate compare to terminal rates, such as the 10-year Treasury rate?
Van Luu: The federal funds rate is an anchor for the 10-year Treasury rate. This is because the 10-year rate is essentially a roll-up of all the serial one-year rates along that time horizon, plus a risk premium in order to compensate for the uncertainty around the forecasted path of short-term interest rates. In general, the peak level of the 10-year is usually not too far from the terminal federal funds rate—and this is evidenced by examining the last three rate-hiking cycles. In each case, the 10-year rate ended up in the neighborhood of the terminal cash rate.
Q: You said earlier that your estimate of the terminal Fed policy rate is 2.25%. So what’s your estimate of the terminal 10-year Treasury rate?
Van Luu: We believe the terminal rate for the 10-year Treasury note will be in the range of 2.25% to 3.0%—and possibly toward the lower end of this range. Just like the equilibrium rate, we see the peak 10-year rate as also being low compared to previous cycles. In other words, at the end of this rate-hiking cycle, the 10-year rate and the federal funds rate will likely be close together.
Q: What does a terminal rate in this range mean for investors in general?
Kevin Turner: There are several implications. First, we believe it’s important for investors to focus not only on where rates may go and the path to get there, but also how this compares with market pricing and expectations.
We know that yield increases typically aren’t great news for fixed income investors, as this generally leads to lower bond returns in the shorter term. For instance, yields increasing 50 basis points (bps) in a given year would typically reduce the value of an existing bond. But what if the market was already expecting rates to rise by 100 bps over this same time horizon—and rates end up only rising by 50 bps? An investor would actually benefit, relative to expectations, by holding such bonds.
This underscores one of our key takeaways here, which is that it’s not just about an investor’s view on rates—it’s also about how that view compares to the market’s view. More specifically related to Van Luu’s comments above, if investors are concerned about the Fed potentially raising policy rates to, say, 2.25%, they should also recognize that longer-term fixed income investments (such as a 10-year bond) are already pricing in the majority of such policy decisions this year.
In addition, rising rates can also be detrimental to equity returns. However, because we believe terminal rates will peak at lower levels than in previous cycles, their influence on long-term equity multiples from here may be lower. In other words, current elevated equity valuations (such as in the U.S.) may be (relatively) more justifiable than if rates were materially higher, such as those seen in previous rate-hiking cycles.
Q: How do rising rates impact defined benefit (DB) pension plans?
Kevin Turner: We all know that (unexpected) increases in rates typically impact short term returns, but in the case of DB plans, the main goal usually isn’t about maximizing returns. Rather, the primary focus of most plan sponsors is their funded status—comparing plan assets to liabilities. In this context, rising rates will usually improve a plan’s funded status.
Why? Because unless interest-rate risk has been fully hedged, most plans will benefit from a decline in liability values to a much greater extent than would be felt in their asset portfolios. This results in a net increase in the plan’s funded status.
Q: So the risk to DB plans is actually from falling rates, not rising rates?
Kevin Turner: Exactly. A decline in interest rates typically increases a plan’s liabilities by more than would be felt in the fixed income assets, thus reducing funded status.
Falling rates are one of the two biggest risks to DB plans, with the other being a decline in equities. A combination of the two is the worst-case scenario for plan sponsors.
Q: Since we’re in a rising-rate environment, why should plan sponsors worry about falling rates?
Kevin Turner: Because the potential Fed policy moves discussed earlier are mostly priced in, and thus reflected in higher longer bond rates today, there is more room to fall tomorrow. Plan sponsors have benefited from recent upward rate moves this year (Treasuries and spreads), but that carries greater risk for the future.
With long duration bond rates up significantly so far this year, there is more potential for any reversion lower to be that much more damaging to a plan’s funded status. So, if anything, the significant rise in rates we’ve experienced this year strengthens the case for repriming the rate-protection pump.
Q: The 10-year is around 2.4%. Does this mean now is a good time to consider hedging against rate risk?
Kevin Turner: Yes, although we should clarify that rates could still move any direction from here. Nevertheless, hedging interest rate exposures is a risk management perspective and, for DB plans, that risk come from downside rate moves.
Since the pandemic began, some DB plans that were not already hedging much of their interest-rate risks were reluctant to do so, because rates were very low. And even though low rates had inflated liabilities, the equity-market environment had been so strong through the end of 2021 that the funded status of most plans had improved regardless. Over the past few months, we’ve seen equity markets fall from their 2021 highs, but we expect that many DB sponsors had been de-risking their asset allocations where appropriate to protect their prior funded status improvements.
Similarly, now that long-term rates have moved materially higher, we believe plan sponsors should also be reconsidering interest rate-hedging policies if they weren’t already doing so.
Q: Let’s expand on that statement a bit. Does this mean that plan sponsors should pay more attention to long-term rates than short-term rates?
Kevin Turner: Yes. Markets tend to focus on the short end of the curve (as evidenced by the current news flow around Fed rate hikes). However, from a plan sponsor standpoint, not all liability cash flows have the same risk. Cash flows further out into the future make up a disproportionate share of the liability risk in a DB plan.
Simply put, longer-dated cashflows are far more sensitive to rate movements than shorter-dated cashflows—which means that what happens to longer-term rates (used to discount these long-dated cashflows) will typically drive the lion’s share of the movement in liability values, and thus changes in funded status.