It has been almost ten years since the return on Government bonds fell below 5%.  But bond returns did not hit bottom until four years later when the sub-prime mortgage market collapsed.  Those conditions threatened the nation’s credit markets, and so, in 2008, the Federal Reserve Board initiated a stimulus program involving the purchase of Treasury bonds and mortgage-backed bonds.  For almost six years, the Fed’s stimulus program supplied demand for low interest debt instruments that did not meet most investors’ objectives.  Last fall, the Fed announced its plan to taper the stimulus program by reducing the Federal Government’s purchase of bonds.  While the Fed has taken the position that interest rates may stay low even as unemployment numbers decline, many investment analysts believe rising interest rates are a matter of time.  The rate at which interest rates climb could have a significant financial impact on many death care trusts.

A decade of low yield Government bonds forced many fixed income investors to look elsewhere for returns.  A significant segment of that market includes 401K administrators who manage accounts for retirees. Death care trusts constitute another major investor in Government bonds.  Death care trusts and 401K plans share two crucial investment goals: income and security.  With more baby boomers hitting retirement age, death care trusts will face increasing competition for Government bonds when rates begin to climb.  That demand may play a role in how fast interest rates could rise.

If interest rates experience a gradual increase beginning over the next few years, death care trusts may be able to adapt with little market value loss.  But if interest rate increases rise quickly, the bond holdings of death care trusts could incur significant market value losses if the funds are not actively managed.

When interest rates do rise, bonds with the longer terms will feel the greatest impact from declining values.  The longer a bond’s maturity, the greater its risk is to market value loss when newer bonds with higher yields are issued.  Consequently, the safe and secure investment favored by some states’ death care laws, the long term Government bond, could actually pose a serious risk in terms of value decline.

Some investors can manage market value loss by holding individual bonds to maturity, but this is not an attractive option for preneed trusts that are required to base performance distributions on market value.  Holding an ‘impaired’ bond to maturity would result in a small portion of unrealized value losses being incurred with each contract performed.  In contrast to equities, market value decline of a long term bond will endure for so long as interest rates exceed that bond’s return yield.

Another strategy against bond investment losses would be to keep a substantial portion of trust investments in cash equivalents.  The return on such funds will increase with higher interest rates but there are downsides to this strategy.  Cash equivalents cannot keep pace with inflation, and the trust will lose ground to rising costs of preneed contract performance during the wait for interest rates to rise.

Bonds may be affected most directly when the Fed raises interest rates, but equities aren’t necessarily immune to the Fed’s actions. Companies that did not take advantage of low interest rates by issuing bonds may see their borrowing costs increase, which could cause their stock value to decline. As interest rates become competitive with the return on stocks, the investment demand for equities could also decline.

Fund managers acknowledge that the Fed’s response to the sub-prime mortgage crisis has created a unique investment environment that is difficult to predict.  Preneed fiduciaries accustom to a conservative investment philosophy now face the challenge of how to implement new strategies efficiently and quickly to multiple trusts, many of which may be relatively small.  For one fiduciary client, such circumstances prompted the implementation of a common trust fund.  Another fiduciary client implemented an investment plan to diversify all of its preneed trusts. In the absence of proactive investment management, the next few years could witness an erosion in the value of many preneed trusts.