Fed raised rates and the market absorbed it without a problem. That seems to be the consensus after the Federal Reserve
Open Market Committee’s announcement on March 15 that it raised the federal funds rate 0.25% to a range between 0.75%
and 1%. This was only the third time since the global financial crisis that
rates were hiked and the first increase this year, but it was a
well-managed event that did not have the dramatic effect on long-term rates
that would have been expected only a few years ago.
After the announcement, long treasuries rates were down about
10 basis points, yet this move was counter to what many expected. However, the
move aligned with what many bond experts were saying about Fed rate hikes for
some time now: Any move the Fed makes will not quickly impact the long end of
As an added surprise, the Fed said it would not raise rates four times this year, as was widely predicted.
Instead, many expected a more hawkish tone about the number of hikes in any
future tightening cycle. To many, this indicated that Fed policymakers will be
less hawkish on monetary policy in the near future.
But this also raises the question: If rising Fed rates
aren’t the “fix” that companies are hoping for, what does this mean for plan
sponsors’ pension plans?
“While the Fed’s move made the news, it was by no means
unexpected, so it had no significant impact on the yield curve. It was already
priced in by the market,” according to Jay Love, US Director of Strategic
Research at Mercer. In contrast, Love said that when Trump won the election
unexpectedly, bond rates rose 100 basis points.
For pension funds, Love said that rising rates are a net
positive for funds since they can generate a better expected return, and in the
corporate world, a rate increase could amplify the impact on a how companies
value their liabilities. For pension funds, rising rates and a modest increase
in inflation helps pension funds, Love said.
This opinion was shared by Bob Collie, Russell Investement’s
chief research strategist, Americas Institutional, who added that “as far as
pension plan funded status goes, all of the excitement and interest in interest
rate movements becomes something of a non-story. It matters a lot, obviously,
to a lot of other investors, but for pension plans, what matters is the middle
and longer end of the yield curve.”
“As a result, it’s
not the Fed rate or the one-year treasury yield that really matters, though both
assets and liabilities are more closely tied to longer-duration instruments.
The one-year and longer-duration treasuries are related, but they’re not the
same. Long-term yields are affected by a wider range of supply-demand
pressures, not just by expectations about the Fed. So, even though loose
monetary policy meant the one-year rate remained low and stable from 2009
through mid-2015, the 10-year rate moved significantly up and down several
times during that same period.”
Based on events
seen at the end of 2015, Collie noted that the market priced in rate increases
that were more gradual. This is why the one-year and 10-year yields were
projected to be essentially equal by the end of 2020. “But while future
expected rate increases remained essentially unchanged, the market expected
that monetary policy will be very different in five years’ time. Now, this does
not imply anything like as big a change in the longer-term outlook. However, history
supports this view: when the Fed has raised rates in the past, longer-term
yields have been much less impacted than short-term,” Collie said.
Rate Increases Alone Do Not Dramatically
As the general rule, bond rate increases can improve a plan’s funding status and lowers
their required annual cash infusions from sponsors. This happens because rate
increases mean that long-term bonds often come under pressure since the
underlying value of existing bonds decreases as new bonds are issued that carry
higher interest rates.
pension plans are complex, so while a rate hike could improve corporate bond
yields that will have a positive impact on liabilities, it is no general
panacea to a plan’s other financing issues, including its unfunded liabilities.
For instance, in 2013,
corporate bond rates rose about 100 basis points and this helped boost yields
for defined benefit sponsors, but this alone did not significantly improve portfolio
returns of DB plans.
According to a report from Strategic Insight “interest rates have remained too low for too
long and now must normalize more quickly given the wide gap to traverse from
¾-1% to 3.5%.
“Normalization requires adopting a systematic program
similar to 2004’s cycle, instead of an arbitrary mantra of ‘data dependency.’ We
expect to reach equilibrium sooner at a level more consistent with the long-run
average than generally assumed. The window of opportunity for a slow methodical
program is closing with a wide gap to the Taylor Rule’s indicated Fed Funds
Rate, already exceeding 2.8%,” according to Strategic Insight. (The Taylor Rule
is used by central banks to make estimates of ideal short-term
interest rates when an actual inflation rate does not match the expected
For funds with exposure to corporate bonds, rising rates
accompanied by a stronger macro economy that raises corporate revenues have a
direct impact on corporate bond rates. A
calculation by Alan Glickstein, a senior retirement consultant at Towers
Watson, found that for every 100 basis point move on the corporate bond rate,
pension liabilities fluctuate 15%.
By Chuck Epstein