Bernanke's Zero Interest Rate: What It Means for Your 401K (And What to Do About It)

by: James Shell

Interest, by definition, is a payment from the borrower to the lender for the use of their capital. The holder of capital needs to be compensated for his or her deferred consumption, as well as other types of risk, including inflation risk, currency risk, and the risk that the borrower cannot repay the loan, that is, business risk.

So by holding interest rates at zero, Bernanke is in effect making money available to his biggest borrowers at no cost. It keeps the interest cost for borrowers of capital low throughout the entire system.

If you have a $100,000 CD, you are hard pressed right now to get more than 1.5% interest, rather than the historical average of approximately 5-6%. Effectively, the zero interest rate policy transfers $3500-$5000 per year out of your account that you should otherwise be getting, even more so since inflation is already costing you buying power. Exactly the same thing goes for conservative 401K holders (like me) who sought low-risk federal money market funds that are considered "safe", but are not compensating me for use of my capital.

So who's benefiting, who's not, and what can those of us not benefiting do about it?

The Winners:

  1. Borrowers: Bernanke's transfer of wealth from your and my 401K is effectively subsidizing a user of capital, who is paying the lower interest rate. Hopefully this will encourage some useful activity such as home buying or investment in some piece of equipment, but the effects of the unprecedented experiment thus far have not been particularly impressive.
  2. The Banks: If your raw material cost is zero, you can be immensely profitable as a lender, particularly in our system of fractional reserves.
  3. The government itself. By encouraging the users of capital to borrow, it evens out the balance sheet a little, offsetting government borrowing elsewhere in the system.
  4. Buyers of non-paper assets. No doubt some of this zero-interest-rate money has gone into the purchase of precious metals, oil, and other non-cash vehicles of storing wealth.

The Losers:

  1. Holders of capital (like you and me) who diligently saved, deferred consumption, and now are not being compensated for our risk.
  2. China and Saudi Arabia: The ultimate holders of capital, are similarly not being compensated for their deferred consumption, particularly if there is an upsurge in inflation which will deprive them of some percentage of their purchasing power on all of those reserves.

How to Adjust your Portfolio:

  1. Corporate bond funds: Maximize the interest rate that you do get by lending it to slightly riskier, but higher-paying users of capital, such as the major corporations. One of the artifacts of the recent downgrading of US Government debt is that at least in the opinion of the bond rating agencies, it is ostensibly less risky to lend in the blue-chip market than it is to the government right now.
  2. Residential Mortgage Backed Securities (RMBS): Yes, these went out with the 2008 housing crisis, but the days of the NINJA loans are gone. Today's real estate borrowers are much more highly scrutinized, and with housing prices at or near the bottom, a number of these funds--such as American Capital Agency (NASDAQ:AGNC), Chimera Investment Corporation (NYSE:CIM), Cypress Sharpridge Investments (NYSE:CYS), Invesco Mortgage Capital (NYSE:IVR) and Two Harbors Investment Corp. (NYSE:TWO)--are paying exceptional dividends right now.
  3. Be a Borrower: One person's wealth redistribution is another person's subsidy.

This week's news is a mixed blessing. There are no guarantees on anything, and of course the system right now is extremely fragile, as we all know.

Disclosure: I am long AGNC, CIM, CYS, IVR, TWO.

Additional disclosure: I went long on the RMBSs last February, and my return suffered from dilution of three out of the five listed that issued additional shares. However, I have benefited from the cash dividends since then, and the question mark at the time, namely Mr. Bernanke's behavior, has now been removed for at least a couple of years and there are some prospects for us chasers of higher yields.I also am rebalancing VSGBX and VBTSX to try to get a little better yield.