Interest Rates

Interest Rates

by Amber Idleman on Mar 20, 2018

Education

After almost a year of calm in the markets, we recently witnessed a sharp pullback in stock values and a jump in volatility. A number of explanations have been put forth as to what caused them, but a common theme among a large number of analysts was the sharp climb in the yield of the Ten-Year U.S. Treasury Bond. From approximately 2.35% in mid-December of last year to almost 3.00% in mid-February. A level last seen in . . . December 2013!

Since then the stock market has calmed down and reclaimed much of the recent pullback. But the 10 year is still knocking on the door of 3.00%. I am not going to address the stock market at this time. Predicting that reminds me of a great saying I heard years ago; “He who lives by the crystal ball learns to eat broken glass”. Although I do think there are implications for the stock market when interest rates rise, right now I am more concerned about the implications for bonds.

A number of investors do not realize that as interest rates rise, bonds fall in value. That’s because unlike a CD, bond issuers do not redeem bonds upon request the way a CD can be redeemed at a bank. Bonds are sold to other investors when the owner needs to cash out. And there is a very large market for bond trading. But a change in interest rates will have an impact on a bond’s value because the bond buyer is in effect taking over the receipt of the existing interest payments. So, when interest rates fall the value of a bond will increase and when interest rates rise the opposite happens.

As an example, the 10-year U.S. Treasury bond is yielding approximately 2.85% as of this writing. If you purchased a $1,000 10-year bond with a coupon of 2.85% and interest rates immediately went to 3.50%, that bond would have a market value of approximately $945. If the rate went to 4.00% the value would be approximately $906. Now it is not likely that rates would move that fast, but rates have been trending upward for the 10-year since they bottomed in July 2016 at 1.36%. And 3.50% - 4.00% were levels we routinely saw in the first decade of this century.

The implication for this is the impact on the bond funds and Target Date funds in you 401k. While individual bonds have a maturity date where the full value of the principal is returned, bond funds do not. They can decline in value and stay down for long periods of time. And most Target Date funds are structured so that over time dollars are shifted away from stock investments to bond investments. On the surface it would appear that you are reallocating from risk investments to safer investments. But that may not be the case. Do you really want to shift more of your investment dollars into an asset class that could be entering a very difficult period?

And the outlook for interest rates? For one thing the Federal Reserve has repeatedly announced that they will be raising short term rates and in a normal environment that impact longer term rates, the kind your 401k funds may own. And then there is the projected budget deficit for 2019 of $1.2 trillion! Yes, that is a “T”! Add to that the fact that the Federal Reserve has announced that they will $50 billion per month run off of their balance sheet starting in the 4th quarter of this year which is when the Government Fiscal Year 2019 begins. And since the Federal Government has been running a deficit for all of this century and does not have any money in the bank, they will have to borrow the $1.2 trillion to cover the deficit and $600 billion to pay off the maturing bonds at the Federal Reserve. Now unless the laws of supply and demand have been repealed, borrowing $1.8 trillion next year will mean a LOT of bond supply will be hitting the markets and normally a LOT of supply means prices go down and yields go up.

 

What this all means is that you should examine carefully what your investment allocation is.

 

 

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