Interest Rates

As 2009 neared a finish, I thought that interest rates, which had been dramatically suppressed by the Federal Reserve, would start to rise sometime in 2011. Boy, was I wrong. Being in the majority of professional opinion at that time didn’t matter either.

Now it is the summer of 2015 and we’re still waiting for our Federal Reserve to raise short term interest rates which will have an influence on longer term rates. Who knows when that will happen and I’ve stopped predicting and making recommendations based upon my personal view.

I thought it was important to remind readers of 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.
  3. Now I’ve set the scene, what are the strategies we’ve previously recommended or are now considering recommending in the near future:
  4. 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.
  5. 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.
  6. 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.
  7. 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.