The Federal Reserve gave pension plans reason to rejoice Wednesday as it announced it would finally raise the interest rate after seven years of near-zero rates.
The Federal Open Markets Committee (FOMC) raised its target for the federal funds rate from 0.25% to 0.5%. The increase is the first in nine years: The Federal Reserve’s last hike was June 29, 2006.
“For bonds to underperform a cash investment, rates do not simply need to rise—they need to rise faster than the market expects.”“This action marks the end of an extraordinary seven-year period during which the federal funds rate was held near zero to support the economy from the worst financial crisis and recession since the Great Depression,” said Federal Reserve chair Janet Yellen in a press conference following the announcement.
Credit rating agency Moody’s estimated the move would “help eliminate” roughly $450 billion from US non-financial corporate pensions’ total unfunded liabilities.
“One indirect policy effect [of ultra-low rates] was increasing pension benefit obligations because of lower discount rates,” Moody’s Senior Accounting Analyst Wesley Smyth wrote in a research note. “Since 2008, our rated issuers’ obligations have risen by $703 billion to around $2.1 trillion. We estimate that $342 billion of this increase was driven by lower discount rates.”
Brad Smith, a partner in NEPC’s corporate pension practice, said the decision to raise rates is a welcome one for pension plans for this reason. As for the asset side, Smith said pensions were unlikely to make drastic allocation changes in the wake of the announcement, having already prepared for interest rates to go up.
“Our clients, for a long time, for the past six to nine months, have been waiting for the Fed to take action,” he said. “A lot of the managers have positioned their portfolios for a rate increase.”
Consensus among asset managers prior to the FOMC announcement was that markets had already priced in the interest rate hike.
“The prospect of modestly higher rates and government bond yields should come as a surprise to no-one.”According to a research note from PIMCO, “since most investors believe that rates will go up at some point, prevailing yields on longer maturity bonds are significantly higher” than the federal funds rate. “For bonds to underperform a cash investment, rates do not simply need to rise—they need to rise faster than the market expects.”
And Wednesday’s rate hike was exactly in line with market expectations, the FOMC having been “very transparent in what they do and very aware in where inflation is and what markets have done,” NEPC’s Smith said.
“The markets really did absorb it,” he added.
In a statement Wednesday, the FOMC said further rate increases would be “gradual,” with the federal funds rate “likely to remain, for some time, below levels that are expected to prevail in the longer run.”
A Hermes Investment Management report predicted US interest rates will peak “some years down the line” at 3.75%, below historic averages of 5%.
David Lloyd, head of institutional public debt portfolio management at M&G Investments, said the FOMC’s move “does not yet represent a watershed”—despite the announcement being billed as “historic” by many commentators.
“The prospect of modestly higher rates and government bond yields should come as a surprise to no-one,” Lloyd said. “For investment grade credit markets rate rises are, to an extent, a vote of confidence in the health of economies and, by extension, in the health of borrowers. Value is becoming increasingly apparent as credit spreads have widened recently. Clearly, high yield is experiencing volatility but this is, of course, primarily caused by weak commodity prices.”
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