Rising Interest Rates and Why We Should Care
A new client of ours recently came into some unforeseen money. With the desire to act wisely and give his cash the opportunity to grow, he told us that he wanted to invest in “something safe.” We asked him if he had any ideas and he responded closest: Bonds. Twenty years ago, we would have agreed that bonds were a safe investment. But with interest rates on the rise as they are today, yesterday’s “sure thing” is fast becoming today’s risk.
Let’s refer to our new client as Bob. Bob is a typical retiree. He lives with his wife, who is also retired, and they have two grown children with families of their own. Bob and his wife both receive monthly social security payments and pensions from their former companies. In addition, they receive IRA distributions from their retirement savings.
Investing in bonds (or bond mutual funds or bond trusts) to supplement pensions and/or social security income has been a typical “safe” move for many retired people for the past 20-plus years. With interest rates going down, seniors who locked into fixed high interest rate investments received chunky interest payments, and in many situations watched their principal go up in addition.
However, nothing lasts forever, and because interests rates are cyclical in character, bonds aren’t necessarily the safe investments that many people view them to be. Let us explain: When interest rates go down, bond prices go up. Now, with interest rates at 45-year historical lows, we think there’s a pretty good chance that rates will start to climb. The Federal save, otherwise known as “The Fed,” (under the leadership of Alan Greenspan) has a huge impact on interest rates. edges will raise their chief rate consistent with federal fund rate hikes. ultimately, after enough short-term rate hikes, we predict that long-term rates will follow. Shortly thereafter, the bond market will have to catch up, and bond prices will be forced in one direction: Down.
So this is how it looks for our friend Bob: Short-term interest rates are creeping higher, while long-term rates have not however caught up. Long bond yields are in the middle of dropping, which method that long bond prices are increasing, due to the inverse relationship between provide and price. Something is definitely wrong with this picture. With interest rates going higher, how can long bond prices be going higher too? Remember what we said about the other important inverse relationship, the one between bonds and interest rates: It’s only a matter of time before the longer bond markets correct and long bond prices start heading down.
If you’re feeling confused by all of these relationships, don’t worry…many financial professionals feel the same way. Nevertheless, you’re probably wondering: What can I do to protect my investment portfolio? Well, this is what we recommend:
1) Review your investment objectives.
2) Review your investment time frame.
3) Ask your broker/advisor what options you have regarding the prevention of loss of principal and income.
The good news for Bob and others like him is that strategies are obtainable to help protect his money. One strategy we recommend involves shortening and staggering maturities of individual bonds so that money comes due on a regular basis. This will allow Bob to estimate the interest rate ecosystem regularly, giving him the option to buy additional bonds at the current interest rate, or waiting for rates to change.
Due to rampant confusion and misunderstandings when it comes to bond investments, it is important to remember the difference between various bonds and bond funds. U.S. government Treasury bonds (T-bonds), municipal bonds, corporate bonds, “junk” bonds, bond trusts, government bond mutual funds, municipal bond mutual funds, etc. are some of the most shared ways an investor can get involved in the bond market. But as with any investment, each of these bond investments has its own ratings, risks, performance predictions, and principal guarantees. For example, with U.S. government bond mutual funds, there are NO guarantees of principal.
We’re not suggesting that Bob should avoid the bond market like the plague, only that he should keep a watchful eye on it. There is nevertheless money to be made by investing in bonds, but with interest rates on the rise, there clearly is an increased possible for loss. Our goal is to help Bob continue a lifestyle that involves choice. We want him to enjoy that upcoming vacation with his wife, the new car every four years, summer camp for the grandkids… Bob has worked hard for a lifetime to make these things happen. By watching his portfolio closely and investing carefully in the bond market, we’re confident that Bob will be able to turn his plans into reality, despite rising interest rates.