Yellen for Higher Interest Rates?

In statements released by the Fed after their most recent meeting, they changed language that opened the door for potential interest rate increases as soon as June.  However, along with that they updated their economic projections to reflect a slightly weaker US economic position, which has many in the market expecting an interest rate increase later in the year.  Either way, the days of near zero short term interest rates are likely coming to an end.

When interest rates rise bond prices fall, so should an investor be concerned?

First, the Fed and chairwoman Yellen have tried their best to telegraph their moves so as to not surprise and shock markets.  The Fed has stated when it begins raising rates they will be in small increments and at a measured pace.  Thus current yields are factoring that in along with the expected timing of the first increase in the federal funds rate.  It would take larger and more frequent interest rate increases to cause a significant move in interest rates and have a major impact on bond prices.

Secondly, the Fed raising the federal funds rate is just one of many factors that go into the market setting the yield on different bonds.  Other issues include market surprises, the financial health of a country or company and their future prospects and how other issues are viewed.  While the Fed may raise interest rates, if there is another shock to the system, a war or a natural disaster, it would likely cause investors to move to safe haven investments like bonds.  As more investors purchase bonds their prices rise and the yields fall.  Similarly, if other countries don’t have as strong a fiscal outlook as the US, investors may decide to continue to purchase US government bonds or US corporate bonds, thus restraining a rise in interest rates.

If rates do rise significantly more than the market is expecting RWM has taken several steps to combat the issue.  First, we tilt the fixed income side of the portfolio from a market neutral allocation, which has an average maturity of approximately 7.7 years, to a shorter term position.  Short term bonds are not as negatively affected by rising rates and thus, all else equal, short term bonds will see smaller losses than longer term bonds.

Secondly, we diversify the portfolio broadly across bond sectors including corporate, agency and government bonds.  Different types of bonds react differently to rising rates depending on the market cycle.  By diversifying the bond portfolio across many types of bonds it enables the portfolio to invest in bonds that are less sensitive to interest rate movements.

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Finally, we diversify the portfolio internationally.  While rates may rise in the US, interest rates can be moving in different directions globally.  By exposing the portfolio to different yield curves it provides the potential to be invested in markets were rates are flat or falling.  Historically, when US interest rates are rising international bonds have posted superior performance.

The concern of interest rates rising is also a relatively short term issue.  As rates are rising the bond funds held in the portfolio are continually reinvesting maturing bonds in new bonds at the prevailing higher interest rates.  As a result the bond funds are buying bonds with higher yields and moving out of older, lower yielding bonds, which helps investors.  Thus, price declines are temporary losses until bond funds move into holding a portfolio of bonds issued at the higher existing rates.

While the Fed is likely to raise the federal funds rate later this year, we believe that the market has already priced this in and it is quite possible that other factors could prevent interest rates from rising.  However, if rates due rise, by having a shorter term portfolio that is broadly and internationally diversified an investor can help mitigate the short term effect rising rates have on a bond portfolio.

 

Index Performance                                    March    YTD      Trl 1Yr              

US Stock (Russell 3000)                                   -1.02%     1.80%      12.37%
Foreign Stock (FTSE AW ex US)                     -1.47%     3.80%       0.07%
Total US Bond Mkt. (BarCap Aggregate)       0.46%       1.61%       5.72%
Short US Gov. Bonds (BarCap Gov 1-5 Yr)    0.40%     0.88%        1.82%
Municipal Bonds (BarCap 1-10yr Muni)         0.13%      0.83%       3.87%
Cash (ML 3Month T-Bill)                                  0.00%     0.00%       0.03%

 

About

Raffa Wealth Management is an independent investment advisor providing nonprofit organizations, high net-worth investors, and qualified retirement plans with a full range of investment consulting services.  We were established to fill the need for transparency, clarity, and vision in the professional management of investment assets.   Visit us at www.raffawealth.com

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