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Bond Fund Managers Quietly Cheer Interest Rate Rise

Investment pros say they welcome a return to normalcy after years of investors searching for yield in increasingly risky places.

  • Julie Segal

In Bond Math 101, students learn that when interest rates rise, bond prices fall. And no fund manager wants the value of their portfolio to decline.

Even so, bond fund managers are cheering, at least quietly, the Federal Reserve’s announcement last week that it would raise the federal funds rate to a range of 0.50 percent to 0.75 percent, an increase of a quarter of a percentage point, with three additional hikes forecast for 2017. Given the Fed’s extraordinary monetary policies since the financial crisis to keep rates low and goose economic growth, bond managers are willing to endure some losses to get rates back to a normal level.

Joseph Higgins, managing director and fixed-income portfolio manager for TIAA Global Asset Management, says existing holdings will obviously get hit, but new investors, particularly individuals, will be able to buy higher-yielding fixed income and diversify out of the riskier alternatives that they’ve been buying over the years in their search for income, including dividend-paying stocks and emerging-markets debt.

Higgins has been doing his best to mitigate the effect of any interest rate hikes for about six months, buying lower-duration securities and floating-rate loans, among other things. Now “higher rates should correlate with better economic growth, and the default cycle could be delayed. That’s a good thing for bond investors,” he says. He also expects higher rates to lure back retail investors who have stayed on the sidelines, worrying about an eventual rate hike.

Some investors have suffered more than others in an environment in which rates have been near zero for years. Insurance companies are one. Thomas Girard, head of fixed income investors for NYL Investors, a subsidiary of New York Life Insurance Co., says no bond fund manager is eager to lose money, but he stresses that investors need yield.

“Any long-term investor in the fixed-income market is happier to buy bonds at a 3 percent level than 2 percent,” says Girard, who manages money for New York Life’s general account and for other insurance company clients. “Seeing rates move to a normal level is a good thing, in our mind,” he explains. Girard hopes, though, that rates move up gradually, not suddenly.

Insurance companies, which invest about 80 percent of their money in fixed income, have been particularly hard hit by the inability to generate income from their assets since the financial crisis. Some insurers have moved into riskier alternatives to find returns, but the industry is constrained by regulatory and other requirements.

“This rate hike is a nice start for insurance companies, but we need it to continue,” says Girard.

The rate rise has revealed how little diversification most investors have within their fixed-income portfolios. Treasury, corporate and municipal, mortgage-backed securities, and core bond funds are all moving in lock-step as rates rise, says K.C. Nelson, portfolio manager of $2.6 billion in alternative long/short credit and event-driven strategies for Driehaus Capital Management.

“I imagine that most managers of fixed-income alternatives are pretty pleased with the rise in rates — I know that we are,” he says.

Ideally, these bond funds should have provided diversification, exposing investors to a broad range of assets. But “the compression in rates over the past several years has morphed these investments into delivering almost exclusively one source of risk and return to the investor, namely, U.S. interest rate risk,” he says.

Nelson says the lesson for investors is to diversify into other assets, such as leveraged loans. “If not, best of luck with the next four or eight years,” he adds.