Many advisors and their bondholder clients are fretting about rate hikes. Here's why they should relax.
Beginning in June 2004 the Federal Reserve raised interest rates a record 17 times in a row, from 1% to 5.25%, over a two-year period ended June 2006. How badly did bond investors do in this period of time? The answer will be disclosed near the end of this article--don't cheat and jump ahead, read the article first, for your own investing good!
Perhaps the question most often presented to us today is, "How will you manage portfolios if interest rates rise?" Of course the fear is that interest rates will not only rise, but rise considerably. Here is what I think:
--An old Wall Street adage says that most of the people are wrong most of the time when it comes to predicting the investment future. Be wary of the investor's epidemic! When just about everyone fears rates will spike tomorrow, our adage tells us that such a dramatic change is highly unlikely to occur.
--Did you know that the 300-year average inflation rate in the United States is less than 1.9% per year? Low inflation is common, not uncommon. We are in a period of low inflation.
--Inflation and interest rates historically move together. With the current lower-than-low interest rates, and without forecasted rises in inflation, we have a long way to go before seeing higher inflation (and therefore higher interest rates).
--Unemployment has a negative correlation with inflation; high unemployment is associated with low inflation. This is because wages contribute such a large amount of overall product and service costs. Unemployment is high and will remain high for a long time to come. Result: continued low inflation and low interest rates.
--The period 1970 through 1990 saw uncommonly high interest rates. Even the 1990s had high rates by long-term comparison. Many of today's investors have grown up in this high interest rate environment. Many homeowners in the 1980s had mortgage rates as high as 16% (yes, 16%, not a typo). Think about that experience and their lifelong perspective on the fear of rising interest rates.
--Safety should keep investors hungry for U.S. Treasuries and help keep interest rates low.
--When interest rates do rise, there is no indication they will rise considerably.
--When interest rates do rise, they usually do not rise in a straight line; they go up a little, down a little less, up a little more, down a little less. To state another Wall Street adage, "there are no straight lines on Wall Street," which applies to the direction and flight of interest rates as much as anything.
--Rising interest rates is not necessarily a bad thing. On the contrary, rising rates would potentially be an indication that sustained economic growth is back. There is also the benefit for fixed income investors to consider--they will be receiving a greater yield!
--Many portfolio managers "ladder" portfolios, which can provide them with a steady stream of maturing bonds to re-invest at the higher interest rates.
Now that I have made the case for a continued low inflation rate, and therefore low interest rate environment, let's ignore that and look at a rising interest rate environment that occurred from June 2004 to June 2006. This is not to say that the past experience will be replicated precisely, but instead for this review is for discussion purposes only.
Special Offer: Richard Lehmann's 2009 total return on his medium-risk fixed-income portfolio was 58%--triple the Dow's return--and it still yields 8%. Click here for new buys and sells in Forbes/Lehmann Income Securities Investor.
Below is a chart of the Federal Reserve Fed Funds Target Rate for the period June 2004 through July 2006. As you can see, the Federal Reserve increased interest rates seventeen times during this period, starting at a Fed Funds rate of 1% and ending at a Fed Funds rate of 5.25%.
Now the answer to the quiz. Below is a listing of various Morningstar U.S. open-ended bond mutual fund categories and their respective annualized rates of return for the period June 30, 2004, to June 30, 2006. Clearly you can see that during this unprecedented rising interest rate time period, bond investors held their own quite nicely.
High Yield Bonds: +6.89%
Intermediate-Term Bond: +2.54%
Short Government: +1.68%
Intermediate Government: +2.05%
Long Government: +3.55%
Are the above outstanding rates of return? No. But investors should never take epidemic, sky-is-falling paranoia as an investment strategy. Interest rates are not going to the moon anytime soon, and if they do rise, investment success is still quite possible--even if your portfolio is brimming with bonds.
By Sean Hanlon, CFP, is the founder, chairman, CEO and chief investment officer of Hanlon Investment Management, a registered investment advisory with $1.8 billion that employs tactical active allocation strategies.
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Perhaps the question most often presented to us today is, "How will you manage portfolios if interest rates rise?" Of course the fear is that interest rates will not only rise, but rise considerably. Here is what I think:
--An old Wall Street adage says that most of the people are wrong most of the time when it comes to predicting the investment future. Be wary of the investor's epidemic! When just about everyone fears rates will spike tomorrow, our adage tells us that such a dramatic change is highly unlikely to occur.
--Did you know that the 300-year average inflation rate in the United States is less than 1.9% per year? Low inflation is common, not uncommon. We are in a period of low inflation.
--Inflation and interest rates historically move together. With the current lower-than-low interest rates, and without forecasted rises in inflation, we have a long way to go before seeing higher inflation (and therefore higher interest rates).
--Unemployment has a negative correlation with inflation; high unemployment is associated with low inflation. This is because wages contribute such a large amount of overall product and service costs. Unemployment is high and will remain high for a long time to come. Result: continued low inflation and low interest rates.
--The period 1970 through 1990 saw uncommonly high interest rates. Even the 1990s had high rates by long-term comparison. Many of today's investors have grown up in this high interest rate environment. Many homeowners in the 1980s had mortgage rates as high as 16% (yes, 16%, not a typo). Think about that experience and their lifelong perspective on the fear of rising interest rates.
--Safety should keep investors hungry for U.S. Treasuries and help keep interest rates low.
--When interest rates do rise, there is no indication they will rise considerably.
--When interest rates do rise, they usually do not rise in a straight line; they go up a little, down a little less, up a little more, down a little less. To state another Wall Street adage, "there are no straight lines on Wall Street," which applies to the direction and flight of interest rates as much as anything.
--Rising interest rates is not necessarily a bad thing. On the contrary, rising rates would potentially be an indication that sustained economic growth is back. There is also the benefit for fixed income investors to consider--they will be receiving a greater yield!
--Many portfolio managers "ladder" portfolios, which can provide them with a steady stream of maturing bonds to re-invest at the higher interest rates.
Now that I have made the case for a continued low inflation rate, and therefore low interest rate environment, let's ignore that and look at a rising interest rate environment that occurred from June 2004 to June 2006. This is not to say that the past experience will be replicated precisely, but instead for this review is for discussion purposes only.
Special Offer: Richard Lehmann's 2009 total return on his medium-risk fixed-income portfolio was 58%--triple the Dow's return--and it still yields 8%. Click here for new buys and sells in Forbes/Lehmann Income Securities Investor.
Below is a chart of the Federal Reserve Fed Funds Target Rate for the period June 2004 through July 2006. As you can see, the Federal Reserve increased interest rates seventeen times during this period, starting at a Fed Funds rate of 1% and ending at a Fed Funds rate of 5.25%.
Now the answer to the quiz. Below is a listing of various Morningstar U.S. open-ended bond mutual fund categories and their respective annualized rates of return for the period June 30, 2004, to June 30, 2006. Clearly you can see that during this unprecedented rising interest rate time period, bond investors held their own quite nicely.
High Yield Bonds: +6.89%
Intermediate-Term Bond: +2.54%
Short Government: +1.68%
Intermediate Government: +2.05%
Long Government: +3.55%
Are the above outstanding rates of return? No. But investors should never take epidemic, sky-is-falling paranoia as an investment strategy. Interest rates are not going to the moon anytime soon, and if they do rise, investment success is still quite possible--even if your portfolio is brimming with bonds.
By Sean Hanlon, CFP, is the founder, chairman, CEO and chief investment officer of Hanlon Investment Management, a registered investment advisory with $1.8 billion that employs tactical active allocation strategies.
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