Why The F Fund Has Been The Worst-Performing TSP Fund Lately

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By on October 10, 2018 in Pay & Benefits with 0 Comments

Businessman looking down at a red 3D arrow chasing through concrete depicting financial losses

The F Fund has been the worst-performing TSP fund cumulatively over the last 3 years. This article takes a look at why this bond fund hasn’t done very well, and describes what would affect its performance going forward.

Last year in February 2017, I wrote an article here on FedSmith discussing how rising interest rates by the U.S. Federal Reserve make the F Fund less attractive on a risk/reward basis than the G Fund for the time being.

So far, this has indeed been the case. Since February of that year, the G Fund has risen by about 4.3% while the F Fund has only risen by about 2%. For 2018 year-to-date, the F Fund has had negative returns. And over the cumulative 3-year timeframe since the U.S. Federal Reserve began raising the federal funds rate in late 2015, the F Fund has lagged behind the G Fund.

Historically, the F Fund has given investors better returns over the long run than the G Fund in exchange for a little more risk. Since inception, the G Fund has given slightly over 5% annualized returns while the F Fund has given better than 6% annualized returns. That may not seem like a big difference, but it adds up over decades.

For every dollar invested in the G Fund since inception in the late 1980’s, you would have a little bit over two dollars today after adjusting for inflation. For every dollar invested in the F Fund since inception, however, you would have almost three dollars today after adjusting for inflation.

However, while both funds are considered rather low risk and help protect a diversified portfolio during a bear market, the G Fund is the less risky of the two, because it has virtually no interest rate risk while the F Fund does. This is because interest rates for the G Fund are reset every month. The G Fund has never had a negative year, while the F Fund has had three negative years since its inception and is on track for likely its fourth negative year in 2018.

During periods of rising interest rates, the F Fund tends to underperform. And that’s what has happened over the last couple of years.

Interest Rate Risk Defined

As the F Fund Information Sheet describes: 

The average duration (a measure of interest rate risk) of the U.S. Aggregate Index was 5.75 years, which means that a 1% increase in interest rates could be expected to result in a 5.75% decrease in the price of security.

The U.S. Federal Reserve sets key short-term interest rates that eventually affect the interest rates of all other debt, ranging from U.S. Treasuries to residential mortgages to corporate bonds. The Fed raises interest rates as needed to keep inflation under control, and reduces interest rates as needed to jumpstart the economy and improve employment rates.

Since late 2015 as the economy has strengthened, the Fed has risen rates by 0.25% seven times:

Recently in late September 2018, the Fed announced its eighth rate hike, which will bring the rate to between 2.0% and 2.25% in the coming months.

The Fed has tentative plans to increase the federal funds rate by another 0.25% in late 2018, and by another 0.25% approximately 3 more times in 2019, subject to economic analysis at that time. By late 2019, unless we have a recession before then, the federal funds rate is projected by the Fed to be over 3%.

All else being equal, a 0.75% increase in interest rates per year is enough to pull the F Fund down over 4% per year. However, this is mitigated by the fact that the F Fund collects about 3% in interest per year on its bonds. The net result at current rates is likely to result in relatively flat or mildly negative performance, which is what we’re seeing in 2018, with the F Fund down -1.48% year-to-date as of the end of September according to TSPDataCenter.com.

Looking Forward

Over the next year, the G Fund which has almost no interest rate risk may continue its local period of relative outperformance to the F Fund. The G Fund certainly doesn’t offer high returns, and barely treads water with inflation at these interest rates, but at least it doesn’t have negative returns.

Fortunately, the Lifecycle funds have a much larger exposure to the G Fund than the F Fund. The Lifecycle funds, which hold diversified investments and re-balance themselves constantly, are among the best ways to invest in the TSP. Stocks historically give the best returns over the long-term, but bonds help diversify and cushion a portfolio through the business cycle, and the Lifecycle funds offer TSP investors an easy solution for diversification.

With another 1% hike in interest rates expected through the end of 2019 in the form of a 0.25% hike every few months, there’s a good possibility that the F Fund will continue its period of relative underperformance to the G Fund for another year.

But what could cause this divergence in bond fund performance to change course? Continued F Fund underperformance into 2019 isn’t a certainty, even if it is somewhat likely.

For one, the yield curve is flattening. The yield curve is the difference between interest rates of longer-maturity bonds and shorter-duration bonds. Increases in short-term rates don’t necessarily translate into direct increases in long-term rates. If the yield curve inverts, we might not see as much of an increase in interest yields of bonds in the F Fund even as the Federal Reserve’s federal funds rate continues to increase, which means bond prices in the F Fund may not decline as much.

Secondly, if a recession were to come earlier than expected, in 2019, there’s a high probability that the Fed would reduce interest rates. And as the F Fund factsheet describes, this can have a very positive effect on F Fund bond prices:

The average duration (a measure of interest rate risk) of the U.S. Aggregate Index was 5.75 years, which means that a 1% decrease in interest rates could be expected to result in a 5.75% increase in the price of security.

Historically, some of the F Fund’s best years were during periods when the Federal Reserve reduced its key interest rate.

The Takeaway

If the Federal Reserve does indeed raise the federal funds rate by another 1% through the end of 2019 as expected, we may be in for another lackluster year for the F Fund. However, an inverting yield curve or an earlier-than-expected recession are two possibilities that could change that outcome.

Overall, both the G Fund and the F Fund have a place in a diversified portfolio. The G Fund is as close to a risk-free investment as you can get, while the F Fund is a bit riskier in exchange for slightly higher return potential. However, an environment with low and rising interest rates happens to be worse for the F Fund than the G Fund.

© 2018 Lyn Alden. All rights reserved. This article may not be reproduced without express written consent from Lyn Alden.

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