Rick Welch: Dollars and $ense

When Rates Go Up

As we move through the final quarter of 2013, we must acknowledge that the three (3) decade long bond bull market may finally have come to an end. The recent dramatic rise in yield of the benchmark ten (10) year US Treasury has provided a significant challenge for fixed income investors – a challenge not seen in many years. During 2013, this benchmark hit a low point of 1.63% on May 2nd and a high mark of 2.98% on September 5th. Rising yields have impacted the prices of fixed income investments (remember when yields go up, prices go down) all summer and into the fall, though the rate of yield change has slowed since the second quarter.

Typically, we associate periods of rising interest rates with expanding economies or rising inflation. This time it is different - GDP growth is a sluggish 2.0% and inflation is below the Federal Reserve target of 2.0%. Few question the premise that the monetary accommodations of the Fed were crucial in kick starting the domestic economy after the recent recession. The unprecedented support of asset prices by our Federal Reserve has helped to repair our portfolios, reduce our mortgage payments and has lowered the cost of capital for American businesses. With the job of stimulating the economy by the Fed near complete, it must now chart a course back to rate normalization. How the Fed leads us back to rate normalization will be an equally large and difficult undertaking. As we follow the path to normalization, we will often hear two (2) terms: tapering and tightening. Tapering refers to a reduction of the Fed’s monthly asset purchases, while tightening refers to when the Federal Reserve will next raise the Fed funds target interest rate. Tightening is unlikely to occur before 2015.

With most projections for 2014 and 2015 showing interest rates to continue rising, why should we own bonds at all? The question should not be “stocks or bonds”. Remember, stocks and bonds do not compete against each other within a portfolio – they are meant to be complementary. Bonds perform some very specific roles in the construction of a portfolio: capital preservation, income generation, management of volatility and diversification. No matter the risk profile or allocation, bonds provide diversification to any portfolio. Bond holdings help investors ride out particularly discouraging bear stock markets. During the worst period of the recent recession (November 2007 to February 2009) when stocks fell -51%, bonds returned +6%. Bonds have lost money (capital appreciation plus interest income) in only two (2) years during the period of 1976 to 2012. Even in the previous worst bond bear market (1994), total losses were just -2.9%. Is selling bonds and moving to cash a viable option? Not really. When it comes to predicting interest rate changes, it is much easier to predict the direction of the change than it is to predict the magnitude or speed of the change.

On October 30th, the Federal Reserve left unchanged its easy money policies, which include monthly asset purchases of $85.0 billion, and gave no clear signal when the amount of monthly purchases would be reduced. Most analysts predict a similar outcome at the Dec 17-18 Fed policy meeting and suggest that tapering may not begin in earnest until the spring of 2014. How far rates have to rise in order to reach a normal level is the subject of much debate. It is interesting to note that prior to the recent recession the same benchmark ten (10) Year US Treasury yielded 4.15% in July of 2008 and 5.0% in July of 2007.

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