Rising Short-Term Interest Rates: What’s Next?
Back in late-2009, I thought that interest rates, which had been dramatically reduced and then suppressed by the Federal Reserve, would start to rise sometime in 2011. Boy was I wrong. Being in the majority of those with a professional opinion at that time didn’t matter either.
Now it is the summer of 2018 and for the past two years, the Federal Reserve has been raising short-term interest rates which have not had much influence on longer term rates, or even mortgage rates. I’ve stopped predicting and making interest rate recommendations based upon my personal view, or should I say hunch.
Still, it’s important to recognize the effects of rising interest rates, so here goes:
1. When interest rates go up, the market re-prices the value of bonds and bond funds down to reflect a better return in newer fixed-income securities. Fixed means the rate promised remains the same.
2. The bonds and bond funds (remember there are many different types of bonds) currently owned still produce the same amount of interest income unless there is a default or non-payment. If you hold the individual bond to maturity it pays you back your initial investment. Bond funds just replace maturing bonds with newer, hopefully, increased return bonds, and the fund slowly rises in value (market price) to reflect these transactions.
OK. Now that I’ve set the scene, here are the strategies we’ve previously recommended or are now considering recommending in the near future:
1. Floating rate bank loan portfolio funds. These funds feature variable rate loans usually credit rated B or better. You pay a professional mutual fund manager to select the holdings.
2. TIPS. Treasury Inflation Protected Securities. These are US government bonds (and many providers have TIPS bond funds) that provide a return of stated coupon rate plus a variable cost of living adjustment (COLA). If interest rates, and then inflation increases, these will become a more popular security or fund.
3. Bond ladders. Individual bonds that sequentially mature in a pattern like $10,000 at the end of one year, $10,000 at the end of two years and $10,000 at the end of the third year. The bonds will be re-priced down if rates rise, but since the maturity is short we know with a high degree of certainty we will get our money back plus interest along the way.
4. Other alternatives? Of course. Just wait and the financial services industry will be hard at work to sell you on the “fear” emotion of loss of principal by offering you lots of products and funds that will make them lots of money and maybe you too. Bonds and bond funds will be like stocks for awhile rising and falling in value based on actions in the interest rate sensitive markets.
Bottom line: This is why we recommend re-balancing. Taking advantage of long-term strategies and percentages allocated to asset classes (bonds can constitute one to three asset classes, in our opinion), we can be prepared for rising short-term and maybe longer-term interest rates.
