Investors Beware: There Is Something Called Interest Rate Risk

Includes: BOND, IEF
by: John M. Mason

I received the following comments from a reader, JasonC, to my post called "Advice To Investors That 'Don't Fight the Fed'":

"You are saying that 'not fighting the Fed' is a specialized hyperactive trader's thing, that few can do. You are wrong.

It is a cautionary rule of thumb that anyone and everyone can practice. Way too many stubborn people letting political opinion drive their trading, fail to do so. And it harms them, materially."

I responded that:

"anyone and everyone can practice... I agree. Do they? No! The majority do not have the training to play this game, the time to devote to the effort, the ability to 'buy' the knowledge needed to play the game, the wealth to engage in the practice or the risk appetite to do so."

And JasonC wrote back:

"Mr. Mason -- for anyone aware that it requires professional understanding and conscious they lack that themselves, all it costs is $200 a quarter and a few visits to a registered investment advisor.

No, that is not something reserved to a favored 10% of blue bloods based on inheritance (what the words mean). It is merely being sensible and awake. Anyone who can find this site and read these comments has all it takes."

Then I read the column by Jeff Sommer in the New York Times on Sunday, "If You're a Bond Investor, Beware the Seesaw". Mr. Sommer begins his article by referring to the latest bulletin issued by the Securities and Exchange Commission. Many of the S.E.C. bulletins, Mr. Sommer tells us, have to do with "investment frauds and scams."

This one is different, however. Mr. Sommer writes: "The problem isn't a new scam but a lack of knowledge about how bonds work, which can be dangerous in a time of rising interest rates. In its bulletin the agency points out that investors need to understand that when rates rise, bond prices generally fall. This inverse relationship is a fact of life in the bond market."

It seems as if "outside trading floors, business schools, banks, and brokerage firms, bond dynamics are fairly obscure…"

It seems as if there is not a wide understanding in the investment community in general about interest rate risk.

Mr. Sommer refers to some research on this:

"A 2012 financial literacy survey by the Finra Investor Education Foundation asked this question: 'If interest rates rise, what will typically happen to bond prices?' Prices will fall, but only 28 percent of adult Americans in the survey answered correctly. Finra ran the same survey in 2009 and got the same results."

Going further:

"The Finra survey found that financial literacy levels were generally very low. On its Web site, it offers a five-question quiz, with questions drawn from the survey-none requiring computations, just an understanding of basic concepts. Only 14 per cent get them all right, it says. (The average number of correct answers is between 2 and 3.)"

This failure to fully comprehend how bond-pricing works is apparently a very real concern of the S.E.C.'s Office of Investor Education and Advocacy. In the current environment, when there is a real possibility that interest rates on longer-term bonds might rise… and bond prices might fall… the S.E.C. feels it is their duty to help investors understand more fully the risks that they might be subject to in their investments.

This has to do with pretty straightforward investing in longer-term bonds.

What I wrote about in the post "Advice to Investors…" was a little more sophisticated trading than that mentioned in the New York Times article. Sam Jones had written an article in the Financial Times about high-powered hedge funds that had followed a two-fold rule for macro-investing. The first rule was "the trend is your friend," and the second was "don't fight the Fed."

Jones contends that these hedge funds, hurt over the past year or so by staying with the two maxims, have now returned to making money by just following the second rule, "don't fight the Fed." My point was that the investors had to be very nimble and competent to play this kind of game and the successful players seemed to be the very sophisticated, or those with access to sophisticated management.

In other post I have been writing about how, in quite a few investment specialties, the "wealthy" seemed to be benefiting from the way the Federal Reserve has been acting over the past three years or so. This analysis was recently supported by Matthew Klein in Bloomberg.

Furthermore, much of this kind of discussion is taken up in the area of Behavioral Finance and Behavioral Economics.

Many investors do not have the knowledge, the ability to access the knowledge, or the wealth to take advantage of what the Federal Reserve is doing for their own financial benefit. As a consequence, not fighting the Fed is something that many investors cannot take advantage of. And yet, this is where a lot of wealthy people are getting wealthier.

This is the search for alpha… and not a lot of the market can really participate in this search for alpha. It is also the subject of investment books like "Snap Judgment" by David Adler.

I believe that we are now in a phase of the interest rate cycle in which there is a real possibility that longer-term interest rates will continue to rise over the next year or two. The yield on the 10-year US Treasury bond has been near 2.60 percent recently and has seemed to weather the onslaught by Ben Bernanke and other Federal Reserve officials in Congressional testimony and speeches attempting to "talk" this rate down substantially.

I don't believe that the Fed will have much success "talking" longer-term interest rates down, but I do believe that these rates will tend to go higher over the next six months to a year. Thus, bond prices will decline from current levels.

However, during this time, my expectation is for substantial volatility in these bond prices. The Federal Reserve, at some time, must "taper" its purchases of securities. We are nearer the time when this will happen than we have been. And with Mr. Bernanke "out-of-office" in January, as most now suspect, the uncertainty over the new Fed chairman, the uncertainty about Europe, and several other things that might or might not occur, will continue to rock the bond market. Interest rate risk is a reality.

And as this drama unfolds, there will be a lot of money made. I just don't think it will be the smaller, less wealthy investor that will be smiling all the way to the bank.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.