The Federal Reserve increased the interest rate a quarter percent in March, and there is a good chance it will do so twice more in 2017, which could impact treasury and bond funds such as the TSP F and G Funds in various ways.
The Fed sets the effective “Federal Funds Rate”, which is the interest rate at which banks lend to other banks overnight and it has begun incrementally raising the rate.
In a high interest rate environment, and/or a falling interest rate environment, the F Fund would generally deliver better returns than the G Fund. On the other hand, when interest rates are so low, the difference in returns between the G Fund and F Fund is very small, and when interest rates are rising (as they are now), the F Fund is at risk of having a mildly negative year while the G Fund generally is not.
The federal funds rate is an important figure, because it trickles up through virtually every interest-related type of investment or loan. The lower the federal funds rate is, the lower the interest rate of treasuries, mortgages, corporate bonds, and other fixed income investments or liabilities tend to be. This includes the G Fund and F Fund.
Here’s a chart from the Federal Reserve Bank of St. Louis of the effective federal funds rate over the past 60+ years:
The Fed lowers interest rates when it wants to increase the national employment rate. Lower borrowing costs incentivizes companies to borrow money to expand their business, which can lead to hiring of additional personnel. On the other hand, they raise the interest rate when employment is already low, when money has been too easy to access for too long, and they are concerned that currency inflation might go higher than their target.
Ever since 2009, we have been in a historically low interest rate environment, as the chart shows. But, over the past year and a half, the Fed has finally begun inching the interest rate back up. They raised it by 0.25% in late 2015, then by another 0.25% in late 2016, and then another 0.25% just recently in March 2017. They expect about two more increases in 2017; probably in June and December, but one can never know for sure until it happens.
When interest rates are low for long, various treasury and bond funds tend to produce poor returns, because their interests rates barely even keep up with inflation. For example, the TSP G Fund has grown by 5.19% per year on average since inception, but only by 1.91% per year on average over the last five years. The same is true for the F Fund; it has returned 6.33%/year since inception, but only 2.59%/year over the last five years. Low interest rates are killing their returns.
At the same time, low interest rates generally benefit stocks, because companies (such as those in the C Fund and S Fund) can borrow money at very low interest rates, and use it for expanding their business or for buying back their own shares, which increases the value of each remaining share.
Ironically, although low interest rates for long periods of time tend to result in poor bond returns, a rising interest rate environment is also bad for bonds. This is because as interest rates rise, newer bonds are released with higher interest rates, and older bonds that already exist must come down in price to match the interest rates of new bonds, because otherwise investors would ignore them for being strictly inferior.
The TSP’s official F Fund Information Sheet quantifies that risk well:
“[The F Fund’s] yield to maturity was 2.57%. The average duration (a measure of interest rate risk) of the U.S. Aggregate Index was 5.72 years, which means that a 1% increase (decrease) in interest rates could be expected to result in a 5.72% decrease (increase) in the price of a security.”
Meanwhile, since the yield to maturity of the G Fund is only a few months, it is much more protected from losing value during rising interest rates. Since its inception, the G Fund has never had a negative year, while the F Fund has experienced two negative years due to rising interest rates and one negative year due to quantitative easing.
Once interest rates are already higher though, or if they start to decrease from a high level, that tends to be a good environment for bonds.
Overall, there’s not much concern for either the G Fund or F Fund, because interest rates are rising so gradually that it may not be enough to push the F Fund into negative territory for the year. The most likely scenario is just a low positive return for the F Fund in 2017.
Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.