For at least the last four years, market prognosticators have been warning investors about rising interest rates, which have been at historical lows since 2009. Rising rates are considered negative for both stock and fixed income investments, but especially for bonds since the value of existing bonds are generally worth less when prevailing interest rates rise. Going back to at least 2010, market strategists were warning of a bond market bubble. In the meantime, four years later, interest rates are actually lower, as seen in the chart below. For this article "interest rate" refers to the 10-year U.S. Treasury bond.
10-Year US Treasury Bond Rate: January 2010 - April 2014
At the beginning of 2014, a monthly Bloomberg survey stated that 97% of economists polled expected the 10-year Treasury rate to rise within 6 months. Four months into this prediction, rates have declined from 3.02% at year-end 2013 to 2.65% at the end of April 2014 - a significant 12% drop. The Bloomberg survey for April had 100% of economists saying rates will rise in the next six months. The rationale for this prediction seems to be that rates are so historically low that they are "due" to rise. This was the same argument made in 2010.
Why are rates so difficult to forecast? Because there are numerous unpredictable and complex factors that affect rates. The most reported factor today is the so called "quantitative easing" undertaken by the Federal Reserve whereby our central bank is buying government bonds on the open market. The Fed has begun to "taper" its bond purchases, but this hardly means rates will rise. After all, the tapering began at the end of 2013 and rates have dropped since then. Besides bond purchases, the Fed also sets the Federal Funds Rate, another benchmark rate. Fed Funds has remained close to 0% for several years and it is unknown when they will be raised; mid-2015 according to many analysts. The Fed recently abandoned its 6.5% unemployment target as an outdated signal for the required economic growth needed to justify raising rates. The current economic data is confusing - the economy grew only 0.1% annualized in Q1 2014, a poor result blamed on the weather. The April unemployment rate showed a significant drop to 6.3%, but the labor force participation rate also declined sharply (matching a low from 1978) rendering the headline number dubious. Another way to look at it: 288,000 jobs were added in April, but at the same time 806,000 Americans "dropped" out of the labor force and therefore are conveniently not counted as unemployed. Other factors that affect rates include worldwide economic strength, inflation (low inflation generally means lower interest rates, and right now inflation is low), purchases of Treasuries by foreign governments, general market demand for Treasuries (which remains robust), and global turmoil. When global turmoil is "high," such as with the current Ukraine crisis, investors seek a safe haven in Treasuries, driving up their price and interest rates lower.
The conclusion is that like stock market predictions, interest rate predictions are doomed to failure, as shown by the evidence over the past five years. Fixed income investments therefore continue to make sense regardless of where interest rates are today. Some investors seem to be "waiting out" the bond market, expecting yields to rise soon with the idea of eventually purchasing these higher yielding bonds. Sitting on the sidelines has not worked for the last five years as rates have remained stubbornly low. Other experts question if there is any "upside" left in bonds. The nature of this question suggests that bonds are a trading play when most fixed income investors should just "boringly" earn interest and hold until maturity. Even though rates may continue to remain flat or down for more years, interest rate risk is elevated simply because rates are low. There are several strategies that an investor can employ to minimize this risk:
(1) Avoid bonds that mature beyond 10 years, and preferably 8 years. Long-term bonds lock you into an interest rate that may be unattractive many years out. If you currently own a bond fund, you may want to scan the holdings and note the maturity dates. If the fund holds many bonds maturing in the mid-2020s and 2030s, it is taking on high interest rate risk. Many municipal bond funds hold long dated bonds.
(2) Focus on owning individual bonds rather than bond funds, and plan on holding these bonds to maturity. By holding individual bonds an investor benefits from a fixed maturity date and can ignore price fluctuations. A bond fund buys and sells bonds daily and offers no maturity date.
(3) Avoid Treasury bonds. Few investors actually need the ultra safety of Treasury bonds (or consider short-term bonds as a cash equivalent only). The extremely low yields are not worth an investment. Higher yielding assets are less susceptible to interest rate risk.
(4) Reinvest income earned into new fixed income assets. If interest rates rise, income earned can be redeployed in these new, potentially higher yielding assets. Compounded interest is a powerful force.
(5) "Ladder" maturity dates, which means owning bonds with various maturity dates. After a few years of this strategy, an investor will always have bonds reaching maturity, which can then be rolled into new bonds at prevailing interest rates.
(6) Invest in floating rate fixed income instruments, such as certain types of preferred stock and bank loans.
Interest rates should be completely ignored as a factor for stock investments. Since stocks should only be part of a long-term portfolio (at least 15-20 years), the movement of interest rates are of little importance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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