Insights for Non-Profits

Many Endowments & Foundations have questions on how to navigate the risks in today’s fixed income environment so they can stay on track towards their long-term goals. Here, we share our perspective on the current risks and how they can be managed.

Why should Endowment & Foundation investors be concerned about fixed income in this environment?

Put simply, interest rates remain very low, and therefore have more room to go up than down. Low rates are problematic because they make it harder for Endowment/Foundation investors to generate income off their portfolios, which can be an important source for meeting ongoing withdrawal needs. Rising rates can be problematic because as interest rates rise, fixed income prices generally fall, all else equal, creating a headwind for future returns.

What’s your outlook for the future of rates?

Today, we still believe the underlying fundamentals of the domestic economy warrant higher interest rates. However, the reality is that an increasingly interconnected world means events from around the globe can influence U.S. growth and ultimately the direction of interest rate movements.

Back in December, the Federal Open Market Committee (the governing body that sets interest rate policy) raised the federal funds policy rate for the first time since 2008 from a range of 0% to 0.25% to a range of 0.25% to 0.50%. However, there have been no formal upward adjustments since, due in large part to market volatility and continued concerns about global economic growth. Policy makers have indicated that while they have the flexibility to proceed slowly with further small increases they might not follow a well-defined schedule. We believe the Fed intends to remain flexible and could potentially proceed slowly with small increases later in the year if markets are stable and economic indicators are encouraging. Most policy watchers expect higher rates in the future unless the economy faces unexpected headwinds, but it will be hard to predict the timing and path of fed funds rate increases.

What investment opportunities are present to help manage this environment?

We think flexibility and selectivity is key. On the fixed income side, we believe opportunities are likely to be in select maturities, credit qualities, and sectors. For example, duration management will be an important factor. Duration is a measure of how sensitive a bond is to movements in interest rates and is closely related to a bond’s maturity. Today, we advocate for a shorter duration, shorter maturity positioning. These are securities that should be relatively protected in a rising interest rate environment as investors can avoid having their assets locked up for a significant period of time before their principle is returned.

Another example is credit securities. These are bonds issued by entities other than the U.S. Government (usually a corporation) and because they’re exposed to credit and default risk, they generally offer higher yields than comparable government backed securities. We take a bottom-up, diversified approach in managing credit. Securities should be analyzed for whether they offer an attractive yield relative to the risk of downgrade or default. Furthermore, spreading out credit exposure across many issuers can help ensure that no single security can meaningfully impair an entire portfolio.

Overall, we think a defensive positioning is warranted on the fixed income side until better long-term opportunities present themselves. At the same time, incrementally higher yields and capital appreciation can be achieved by opportunistically overweighting certain areas of the market.

If bonds are so challenged, should we reconsider the amount allocated to Fixed Income?

For most long-term non-profit portfolios that make ongoing withdrawals, an allocation to fixed income is still very much warranted, even if there are headwinds to return in this segment. This is because, relative to stocks, bonds still appear to be well positioned to help preserve capital and temper volatility when markets get rough (some bonds more so than others).

At Manning & Napier, our security selection strategies are the primary tool for determining how portfolios are allocated. Those strategies, in turn, are based on the opportunities in the market. For example, when Manning & Napier’s strategies and pricing disciplines indicate that stocks offer attractive returns, portfolios will own more stocks. Likewise, when our strategies and disciplines imply that bonds offer more attractive returns, portfolios will have a higher bond allocation. As such, a key component of our process is to actively adjust asset allocation within a permissible range established by each client’s investment policy. Today, our multiple asset class portfolios are generally near their midpoint of allocation ranges between stocks and bonds, meaning that we don’t see a strong reason to overweight either segment. Bonds do face significant risks, as we’ve discussed above, but stocks don’t broadly appear to be a clear cut alternative. In both segments, it will pay to be selective and flexible.

What about our policy allocations?

We also believe it’s incredibly important for Endowment/Foundation investors to confirm and if necessary, reestablish appropriate investment policies in light of the environment. Yes, the precise allocation between stocks and bonds is important, and should be determined by the opportunities in the environment. But perhaps what is more important is the framework of allowable allocations that a manager must work within. Trustees may wish to ask themselves: “what portfolio guidelines are appropriate for us?” This is a much more timeless decision that should be based on a portfolio’s goals and fundamental characteristics like time horizon, withdrawals needs, and risk tolerance.

Manning & Napier remains a resource to help our Endowment & Foundation clients monitor these characteristics (i.e., time horizon, withdrawals needs, and risk tolerance) and reassess their investment policies if necessary.

For more information on this topic, listen to The Hidden Risks of Fixed Income for Endowments & Foundations webinar replay.