The Coming Implications of Higher Interest Rates (How One May Adjust A Portfolio For Them)

• IRON100
• June 27th, 2010

I just received this month's copy of the AAII Journal for June 2010 (American Association of Individual Investors, www.aaii.com). If one is not a member of this organization (which I think one should be), go to your local library and read the article shown on Page 6 of this edition for the article called "Deficits, the Fed, and Rising Interest Rates:  Implications for Bond Investors".

As many retail investors abandon the stock market for what they think are "safe" returns offered by bonds, what they fail to realize the potential risk to investment principal (the amount invested) that is caused by an interest rate rise. With mounting Federal, state, and even local deficits, all bond categories (U.S. Treasury Bonds, State General Obligation Bonds, and even local municipal bonds) are facing lower tax receipts with the slowdown in the economy. As a result of this problem,  the risks associated with default (particularly at local and state levels, where there is no U.S. Treasury printing press to print one's way out of a deficit, will likely mount dramatically if the economy does not improve over time.

What is interesting about this article (and yes, I am the pragmatic type that tends to scoff at doctoral dissertations by PhDs like Joseph Davis, the author of this article) is that it presents some solid facts and some differing scenarios from the tame to the truly scary with regard to the evolution of future interest rates.

The three major highlights of the article are really pragmatic, and I am going to do my own little spin on them (if for no other reason but to make you go to the library and read the article).

The three points are:

1) The next rate tightening cycle by the Federal Reserve could cause the gap between short-term and long-term rates to narrow (that is not exactly rocket science, but it has very serious implications, particularly for savers and for retirees). That kind of move can kill a bond portfolio (particularly a bond fund portfolio).

2) Long term bond yields and Federal debt levels are NOT correlated. That is backed up by extensive data too.  That can force one to consider figuring out how to spread the risk over many bond duration levels, which brings us to the final point.

3) Uncertainty about where future rates will be supports greater NOT lesser, fixed income diversification. That means across classes of Treasury and State debt as well, in my opinion, because some states are more fiscally responsible than others, and that will cause call dates and interest rates to vary wildly if the politicians continue to spend their states (and this nation) into oblivion.

I hope everyone understands point 1, and for those of you who do not, perhaps I will discuss that at a more elementary level in another post. I am not trying to berate readers at this point, I simply want to discuss what I think are the significant conclusions of this article in the context of current investment strategy.

Point 2 might blow many people away (including yours truly), but it does make sense at a couple of levels. Why is there no direct correlation between Federal Deficit levels and long-term U.S. Treasury Yields? Though the standard deviation of that data might be high, one of the assertions that makes sense it that as long as 1) investors INCREASE their long-term savings rate and 2) investors are WILLING to fund the deficit by buying bonds, the yields can indeed remain relatively stable. My biggest concern with this assertion is that we have never seen such obscene levels of unfunded Federal liabilities since the founding of the republic, and that at some point, there has to be a breakdown of those smoothed interest rate forecasting estimates that can only see long-term U.S. Treasury Bond yields in 2015 being perhaps 5.6%. Yet, Japan's yields have remained very close to zero because that has been their exact response. They save like the ant in the fable and are willing to shoulder the debt.

Apparently, if one believes the study produced recently by Bloomberg, then one could imagine that one would want to:

1) Spread one's fixed income reserves rather evenly across the duration spectrum between short-term and long-term yields to absorb the shock of what might happen to short-term yields (as they would rise the fastest on a percentage basis over time), and

2) Spread the risk across treasury, corporate, and municipal bonds within states that have lower fiscal concerns than others. What makes the point about municipal bonds so hard to define is that (particularly in South Carolina, where I live) no one can be sure of what fiscal policies or disciplines will be for each administration that enters the Governor's Mansion. This will require real discipline on the part of the investor. The research and discipline required to invest in this environment, in this writer's view, can NEVER be relaxed. Things change more than they stay the same in state fiscal affairs. Anyone familiar with New Jersey or California knows what I am talking about.

There is also likely a point 3 in this mix as well. That point 3 is that one should have at least some 6-month emergency cash fund (which would be in that money market account), and if one is concerned in the short run with cash needs to build a ladder of Federal Deposit Insurance Corporation (FDIC)  insured certificates of deposit (CD). By a ladder I mean an even distribution of CDs with maturities form 3 months to perhaps 2 or 3 years) for cash one might need in a relatively short time frame. You could do the same thing with individual bonds too, but realize that corporate and municipal risks are not always backed by a printing press the way U.S. Treasuries and FDIC-backed CDs would be. Remember, when one keeps a CD or bond to maturity, one gets every penny of principal back from the borrower. That is not always the case with a bond fund.

The very last point I want to make is as obvious (to me at least) as point 1. If one chases yield in long-term bond funds and does not have the stomach to hold them, one WILL lose money in them (and in some cases rapidly) if interest rates rise DRAMATICALLY. I know people hate to hear me say this, but in that regard, it is ALWAYS a good idea to diversify not only in terms of yield, but also in terms of the term of the fixed income investment. The long-term damage one can do to one's portfolio can be devastating to principal if one chases high yield for long periods of time. In an economy that has some high potential risk for inflation, a spike in yields can destroy the net value of any bond portfolio even more than one might destroy it via bad equity investments.

Tickers: certificates of deposit, correlation of bond yields to Federal Debt levels, desire of investor to shoulder national debt, duration, FDIC insurance, FDIC insured CDs, increase in savings rates, interest rate increases, interest rate risk

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