401k Insights - Quarterly Newsletter
The winter thaw is in full swing, taxes are due on April 18th, and we find ourselves in a year of possible Federal Reserve Board (FED) Interest rate increases. While springtime isn’t specifically associated with interest rate increases, our economy is robust and the FED is finally signaling that sustained rate increases should be coming in our immediate future. This quarter we are helping link the relationship between bonds and interest rates.
Mechanically, the FED has the power to change the Federal Funds rate, which is the interest rate that banks charge each other for overnight loans to meet their Federal Reserve Requirement. This rate then permeates through the financial system and affects everything from mortgage interest, credit card rates, and bonds that you may hold through one of the funds in your 401k account.
This monetary policy is one of the control valves for regulating inflation. When inflation is on the rise and the economy is perceived to be overheating, rates are increased, taking money out of the system. When inflation is too low and the economy needs to be jump-started, rates are lowered, and more money is made readily accessible to the economy.
Over the past few years we have seen an extremely low FED Funds rate, between 0.25% and 1.0%, since the Recession of 2008-2009. The increase that occurred on March 15th, 2017 is just the third time an increase has happened since the aforementioned recession that ended in March of 2009. The FED has been eyeing various data points including but not limited to unemployment numbers, expected Inflation, and the moves made by other Federal Reserve’s to stabilize their countries markets.
These increases have a direct effect with bonds and interest bearing investments that are found in many of the Mutual Funds that you hold in your retirement account. Interest rates have an inverse relationship to the price of bonds. When interest rates rise, the price of your bond falls, and vice versa. This means that a bond’s price, when sold prior to maturity, will be lower than when it was purchased during rising interest rates.
Fund managers are tasked with ensuring a portfolio’s bond duration and credit risk is in line with the funds objectives stated in the prospectus. Therefore, they may need to buy or sell bonds/fixed income instruments to meet their objectives. Because of the anticipated 3-4 interest rate increases this year, a slight underperformance in funds with significant bond exposure may occur.
This does not mean we are recommending that you sell all bonds now and go to stocks/equities. We believe that long-term investors should remain invested based on their risk tolerance which may include bonds and interest bearing investments.
What it does mean is that your individual returns will not reflect that of the broader indices like the S&P 500 or Dow Jones Industrial Average (DJIA). These indices are completely made up of stocks/equities from the largest listed companies in the US. They do not represent interest bearing investments. Please keep this in mind as prudent investors will have fixed income holdings, thus their performance will not match that of the S&P 500 nor DJIA.
Should you like to go into more detail with us regarding this or any other topic, please feel free to contact us at any time.