Interest Rates and the Gag Reflex
April 21, 2017
If you were paying attention to our last article…
Interest rates are near a 5,000 year low. Is that good news? The answer, of course, is: yes, maybe, and no. Is it bad news? Again, yes, maybe, and no. How can that be?
Well, most of us are savers, investors, or borrowers. Depending upon what we have most of, savings, investments, or debts, the answer is each of the above and maybe more than one of the answers in each case.
Savers, if you have been disappointed and disillusioned with your returns for the last ten years, then maybe things will begin to improve for you. Do you want the good news or bad news first? Good news: your earnings may increase beginning soon. The bad news is you won’t notice it very much because any rate increases will be minimal for the foreseeable future, and banks are notoriously slow in passing along those rewards to customers. The chances are better that you will get a new toaster (remember those days?) from the bank before you get a meaningful increase in return.
Borrowers, (want the good news or bad news?) you will definitely see those increases first. If you have not refinanced your loans and locked in these historic low rates, you are rapidly running out of time. Yes, they are already higher than last summer, but are likely to go much higher. In fact, the longer you can make your loan, probably the better. If you have any floating rate loans….do not pass go but run immediately to your friendly banker and convert that loan to a fixed rate loan. Yes, you will probably have to pay more than your short term alternative in the short run. However, in the long run, you will be glad you did. Why? By the time your short term loans “re-set” and you decide to lock in a longer term loan, those rates will also be higher. If you ever owned a dog and wondered what it felt like chasing its tail, you will find out. Worse, you will also be frustrated in having missed an opportunity that may not present itself for decades, unless we have a depression or recession.
That leaves investors. Will they be happier? Yes, maybe, and no. That depends, as always, on the types of fixed income investments that they own. This is where the GAG REFLEX starts to kick in. Here we must start getting more technical and begin to analyze the investment alternatives …which may be less pleasant than experiencing a root canal without anesthesia.
One of the truisms of investing is that risk is usually a function of reward. You may have heard that there is no such thing as a free lunch. In the fixed income markets, there is usually something known as a “positively sloped yield curve.” In lay persons’ terms, the further one goes out in time, the greater the return. However, the further one goes out in time, obviously the greater uncertainty one assumes. From the memory bank, remember when 1 year CDs paid 1%, 2 year CDs paid 2% and 5 year CDS paid 3%? That was a positively sloped yield curve. What if you could buy a 5 year CD or Treasury Bond that paid 5% or even a ten year bond that paid 7%? Why would one not make that investment today? First of all, those investments do not exist. But if they did, what would you do?
Answer: most people would opt for the higher return. Why not? What could be wrong with that? Well, first of all….life happens. We know that 5 years, and certainly ten years, is a long period of time. Over that time frame, your conditions may alter and you may need to access your investment. Of course, you may have alternatives to come up with needed funds from other sources. But what if those funds are invested in Real Estate, or the Stock Markets and they are not doing well? Has that ever happened before? As a result, your “safe money” may be in that ten year bond and the only logical alternative (i.e. the least painful alternative to pursue) to access. How bad could it be? Answer: that depends upon how much interest rates have moved up. Remember, we are at or near historic lows in interest rates which means the path of least resistance is UP. Bond prices and interest rates are inversely related. Lay terms again: they move in opposite directions. How much? That depends upon how much interest rates increase and from what starting point. The further out on the yield curve, the greater the volatility.
Well, you may be asking yourself, “What if I don’t invest in bonds per se, but invest in mutual funds or ETFs (exchanged traded funds)?” If it walks like a duck, squawks like a duck…. then I think you get the point. It will act the same way. If mutual funds (bond mutual funds) and ETFs are invested in ducks, I mean bonds, then they will act exactly the same. In fact, they could even perform worse.
For example: assume one invested in a ten year bond today and interest rates only increased 100 basis points (i.e. 1%) over the next two years. What would be the value of that bond as an 8 year investment at that time? I know, this is hypothetical. However, although moves of that magnitude do not occur frequently, they did move a greater amount than that just last summer from July to November. The ten year Treasury Bond yield moved from 1.36% to 2.65%, an increase of 129 basis points (bps). It is now at 2.52%. However, assume that 100 bps move took place over a two year period. The value of that bond would decrease to 93.074 from 100. What that means is that you would have lost more funds than you earned over that time period. (You earned 2.52% for two years which equals 5.04% in yield, but lost 6.93% in price.) If the rate increase was greater or took less time to do so, the results would mean greater losses.
What if rates went up another 1% the next year making it only a seven year bond to maturity, what would it be worth then? By then, your seven year bond would only be worth 88.104. Again, your earnings would have been far outweighed by your loss in value. By the way, as stated in the above examples, the longer the maturity, the greater will be the loss. Many investors own bond funds with longer maturities than above but are just not aware of what it is in which they have invested. The math behind the 30 year Treasury would make you more than just gag. Hello, Ralph?
However, the point to this article is to follow up on the article of March 6, 2017. Many investors are either worried about their investment alternatives and merely cannot afford the risk that today’s high market valuations represent, or are oblivious to them. Yet they do need some return beyond what the traditional short term alternatives currently provide. In a word: NADA! As a result, they may be investing in only that which is left; bonds. However, as you can see, bonds today are not without risk……unless you believe interest rates are either not going up or maybe even going down.
If so, please call. We have a certain bridge in Brooklyn that we can obtain for you at a very, very good price.
Rather than providing additional examples behind the math in this article, should any one care to have more specifics, please contact our office and we will provide those examples based upon various scenarios. Even I am starting to gag with all of this math.
By HERMAN RIJ Special for Lehigh Valley Business, April 17, 2017
Herman Rij , Founding Partner of Quadrant Private Wealth, Private Wealth Advisor, in 2014 and has over 46 years of industry experience He holds the Certified Investment Management Analyst ® (CIMA®) designation . He has been named as one of Barron’s “Top 1000 Financial Advisors in America” in 2009, 2010, 2011, 2012, 2013 and 2014 and in Registered Rep.’s “Top 100 Wirehouse Advisors in America” in 2009. He earned an MBA in Finance from Lehigh University and a Bachelor’s degree from Albright College.