The Fed, rates and your bonds

The S&P and Dow each set new all-time highs on Friday, with the NASDAQ closing at its highest point since March 2000, within just 4% of its all-time high set at that time.

Having done nothing much the previous few sessions, Friday’s result was due to the Greeks and eurozone finance ministers having agreed to take a page from our intrepid US Congress. By the Euros deciding to kick the can out four months on actually having to make a decision, the result was a relief rally.

As has been the mantra during this entire recovery – especially when we’ve hit new highs – skepticism remains the main focus and many are saying that the market is overvalued.  If you use historical averages, then, yes – the trailing price to earnings (P/E) ratios have moved above those levels. However, those interpretations don’t seem to consider our record low interest rates. Once you factor those in, the current prices and P/E numbers fall well within those historical norms. My conclusion from that? We still have room for stock market growth from here.

The Fed notes

The Federal Open Market Committee released their January meeting minutes last Wednesday. In them, the Feds said that they remain positive on the US economic outlook. And, while lacking any specifics, it still appears as if interest rates will be rising at some point this year. This fact has been demonstrated by the rise in the US 10 year Treasury Note return. The historic low for the 10 year was set in July 2012 at 1.40%. We began this month with the 10 year at 1.68%. It closed at 2.12% yesterday. (That move this month is considered large in bond rates – ask anyone in the mortgage loan field…)

Additionally, the Fed minutes again included concerns about “liquidity pressures” in the bond market…something that would be affected by rising rates. Here’s the quote.”Finally, the increased role of bond and loan mutual funds, in conjunction with other factors, may have increased the risk that liquidity pressures could emerge in related markets if investor appetite for such assets wanes.”

And so what the Fed is basically saying here about liquidity pressures, the desire to move out of bonds and/or bond funds and move into cash, is that there could be a problem for bond investors if or when they want to get out of these funds at about the same time. The result would be significant drops in price from the large increase in bonds for sale, combined with the outside pressure of rising rates.

Bonds 101

Regardless of issuer or credit rating, all bonds, and most securities which trade like bonds, i.e., preferred stock, utility companies, etc., have this trait in common. Interest rates and asset prices move in the opposite direction. Therefore, an increase in rates would produce a decline in price. That is particularly significant in today’s ultra-low rate world. Here’s what I mean.

When they’re first issued, and then priced over their lives, all bonds in the US, and most developed countries, base their stated rate and subsequent price upon their respective Federal government issues. As of 20 Feb, here are some examples of global market rates for notes due in 10 years. Again, ours is 2.12%. The UK is paying 1.76%. Italy is at 1.61% and Spain is at 1.51%…and these are at the “high” end. France is paying 0.62%. Germany and Japan are each at 0.39% and Switzerland, not a misprint, is “paying” 0.05%. Understand that these rates are locked in for 10 years. Great for borrowers; definitely not so good for savers/investors.

Here’s a major challenge that most investors/savers don’t consider cuz it’s never happened to them. Very few of them have lived through a rising interest rate environment and a bond bear market. That’s because, for more than a generation, fixed income investors have been living in a falling interest rate environment. Seems to me that we’re at the end of that ride.

Recalling that interest rates and asset prices move in the opposite direction, these folks have had a wind at their bond investing backs since September 1981. That was when the US 10 year had a return of 15.82%. So, they’ve pretty much seen their fixed-income assets either rise or hold their value for all that time. Perhaps that partially explains why, according to the Investment Company Institute (ICI), even after five years of stock market growth, that $60 Billion net moved out of stock mutual funds in 2014 while $44 Billion net moved into all bond funds – even at historic low returns. Might want to file this under ignorance is bliss…

What are bond investors to do?

What about those investors who are concerned rates will make a move up?

Speaking to the Fed’s concerns about liquidity, first thing to realize is that when you own a bond mutual fund, of whatever type, you don’t actually own a bond, you own shares of the fund. Bond funds rightfully only keep so much cash on hand. So, if investors in a fund all want to redeem their shares at the same time, it could pose problems for the fund manager in trying to meet those requests. Most likely, the manager will be forced to sell bond holdings, potentially at a discount, as the fund needs to simply raise cash to meet redemptions.

Multiply this over the many bond funds out there and you get an idea of why the Fed is concerned.

Prior to having to act under duress, you can evaluate your current holdings to determine your principal loss potential due to rising rates. You do that using the duration measurement.

Duration

Duration is a measure of how much the price of a fixed-income instrument can change in response to a move in interest rates – up or down. It’s my conviction that with global rates at these historic low levels and with our economy moving well into self-sustaining mode, interest rates will be rising. While the timing is uncertain, the speed and magnitude of the rate moves will directly affect the prices.
Other factors influencing duration include the length of time until a bond comes due, its credit rating and its rate of return, relative to prevailing rates.  A good rule of thumb is that the higher the duration of a bond or fund, the greater the sensitivity to moves in rates.
For reference, in terms of US sectors, investment grade bonds – including US Treasuries – currently have a duration of more than 7 years. Tax-free issues are at about 5 years. High-yield bonds, due mostly to having stated rates of return usually above that of other issues which may outweigh the price decline, come with the lowest relative duration of around 4 years
I recommend you review the holdings pages of your funds. Somewhere on there you’ll almost always find the duration of that particular fund. It varies by fund so you’d have to check each. I further suggest that, if you find relatively high numbers, you search for other funds of similar quality to those you own – but with lower durations – and reallocate.

If would like help with this or have questions, please email or call me for a no obligation review.

Cheers!

Mike

Securities and Investment Advisory Services offered through KMS Financial Services, Inc.

To get an overview of economic conditions, use this link. It’s updated monthly. http://www.russell.com/Helping-Advisors/Markets/EconomicIndicatorsDashboard.aspx

Past performance is not indicative of future returns.

Investing in securities of any type involves certain risks, including potential loss of principal. Investment return and principal value in a bond and/or securities portfolio will fluctuate so that investments, when sold or redeemed, may be worth more, or less, than the original investment.

Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.