Managing Bond Investment Options When Interest Rates Rise

In the face of rising interest rates and concerns about bond holdings in a retirement portfolio, “TDF investors should do nothing,” Matt Sommer, director of the retirement strategy group at Janus, tells PLANSPONSOR. The reason is simple: the asset allocation in a target-date fund (TDF) is being capably managed by the provider, he points out. “One of the best parts of a TDF is, it takes a lot of the decision-making off the hands of the participant.”

Plan sponsors should tell their plan participants not to worry, agrees Matthew Brancato, head of Vanguard defined contribution advisory services. “A lot of folks concerned about rates should take comfort in the fact that TDFs are built to be enduring solutions, to withstand different market conditions because of the diversification built into the portfolio,” he tells PLANSPONSOR.  

Vanguard analysis shows that under the likely rising rate scenario, wealth in a portfolio will take a dip when interest rates rise over the very near term, according to Brancato, co-author of “Rising Interest Rates: Weighing Risk for TDF Retirees.”  

“But the higher coupons associated will benefit investors who are in their portfolio for the medium term,” Brancato says. “What many people worry about is not a real concern.”

Since the Federal Reserve raised rates in December, it makes sense that people are starting to wonder if we are at a critical inflection point when it comes to rates, Sommer says. With rates possibly on the way up, people might wonder if bonds still have a place in a 401(k). “People realize bond prices and interest rates are inversely related,” he says, so it’s natural for some to worry they might lose money by staying invested in bonds.

Janus has been scrutinizing the period 1954 to 1981, when the 10-year Treasury went from 2.5% to almost 14%. “One has to assume you lost money in bonds,” Sommer says. “But interestingly enough, the intermediate-term government bond index averaged 4-1/2% during that period of time. If rates went up, how did you generate a 4-1/2% return in bonds? Don’t bond prices go down when interest rates go up?”

A rise in rates can carry some good news, Sommer says. “As older bonds mature, you’re able to reinvest the proceeds into newer, higher-yielding bonds. It’s not just about the bond price.” Another factor that might go unnoticed, Sommer says, “Very few of us were investing in the bond market [in that period]. Many of us who own bonds and investment committees who make these decisions on behalf of plan participants have only seen a cyclical bull market in bonds.”

Sommer also recommends that plan sponsors and their investment committees compare the performance of the core bond manager during volatile periods with that of the equity manager. “Look back at the performance during the Great Recession,” he says. “Bonds are supposed to be a diversification agent, not correlated with equities. It’s up to the bonds to buoy people’s portfolios, to buoy balances. If they’re so aggressively invested that they’re correlated with equities, then it’s going to exacerbate the decline in values.”

For plan participants that take a more active hand in their own investments, plan sponsors need to be sure the lineup provides the right options for bond holdings, whether in a qualified default investment alternative (QDIA) or for standalone bonds in the core lineup. Sommer points out the average number of investment options is 18—but in most plans, only a couple of these are bond options. “A lot of equity options, but very few bonds,” he says. “Plan sponsors seem very deliberate in filling out the Morningstar style boxes,” he says. They exhibit care in choosing all the equities, but by the time it gets to how many bond options to offer, they seem to fall victim to the same overwhelmed feelings that affect plan participants when they confront too many choices.

Plan sponsors should offer five fixed-income options, according to what Janus calls the framework of five. “It’s not too many, and it’s not too few,” Sommer says. The first one should offer capital preservation through stable value or a money market fund. The second option should be some type of short-duration bond investment, which doesn’t present too much risk but certainly gives much more yield.

Next is a core bond fund, also known as core plus. Fourth: what Sommer calls a “go-anywhere” fund that is more aggressive than the core bond fund but has more potential for return. This could be a global bond, multi-sector or strategic income bond fund. Last is a bond fund that offers some inflation hedge. Sommer recommends a real-return option, which he says some might categorize as an alternative.

Janus firmly believes that bonds have a place in a plan participant’s long-term strategic allocation, but education is critical to ensure they don’t make uninformed decisions. “Yes, if rates go up, bond prices may go down, but there is much more to the story,” Sommer says.

Giving participants a more three-dimensional understanding of bonds and interest rates is important, since one definite area of concern, says Brancato, is an overreaction to what could happen in the bond market. “People would either increase equity exposure or move into a high-yield bond portfolio or a corporate-centric portfolio,” he explains. Any of these reallocations could present risk because they reduce diversification, especially if the expected rate raise does not occur. “If what happens instead is an equity bear market, what you’ve done is reduce the shock absorption in your portfolio,” he says. “That is something to be concerned about. When equity markets head south, they can really head south.”