Strategies for the Current Low and Rising Interest Rates Environment

srategyNo one knows for certain whether interest rates will rise or fall, how much they will rise or fall, and how quickly they will rise or fall.  The odds are far in favor of interest rates rising though.  As of 2/22/13, the 10-year U.S. Treasury yield was 2.0%.  Per the February 2013 Wall Street Journal Economic Forecast Survey (of economists), the 10-year U.S. Treasury yield is expected to be 2.4% in December of 2013, 3.0% in December of 2014, and 3.6% in December of 2015.

  To see a list of high yielding CDs go here.  

In the five years prior to the U.S. financial crisis, 10-year U.S. Treasury yields ranged from 3.3% to 5.3%.  There are good reasons to believe we will return to yields like these in the not too distant future, as the world slowly returns to a more normal financial state.  There is a foreseen (possibly this year) end to U.S. QE (quantitative easing), there is an exit strategy for reversing U.S. QE, and there is a vision of increasing the federal funds target rate from its current 0-0.25% in or about 2015.

The key question for investors is:  “What actions should I take in response to this situation?”  Here are some good strategies that investors can use in response.

Good Strategies

 

(1) Buy Individual Bonds and/or CDs, Vs. Bond Funds, and Hold Them to Maturity

If you buy individual bonds and/or CDs and hold them to maturity, you will not lose principal because interest rates rose.  By far, most bond funds do not hold their bonds to maturity; and they lose principal when interest rates rise.  These principal losses can be rather large when the bond fund holds long-term bonds.  The longer the term of the bonds and the greater the rise in interest rates, the greater the losses.  For example, the iShares 20+ Year Treasury Bond ETF (TLT) figures to lose about 24% of its principal if/when interest rates return to what they were prior to the U.S. financial crisis.

If you buy longer-term bonds and/or CDs, you will get higher interest rates.  If you buy shorter-term bonds and/or CDs, your bonds and/or CDs will mature sooner; and you can use the principal return proceeds to buy bonds that are expected to have much higher interest rates than are available today.  Based on this logic, it may be good to target more of your fixed income holdings than you normally would to mature in about 2017.  Currently at least, for investments of five years or less, well-chosen CDs are, generally, the best investment-grade choices.

 

(2) Buy Bond Funds That Hold Bonds to Maturity

There are bond ETFs that hold their bonds to maturity.  These bond ETFs are offered by Guggenheim and iShares.  The Guggenheim ETFs are called BulletShares.  Currently, there are investment-grade corporate bond BulletShares ETFs with bonds maturing in 2013-2020 (with a separate ETF for each target year); and there are high-yield corporate bond BulletShares ETFs with bonds maturing in 2013-2018 (with a separate ETF for each target year).  Guggenheim is considering offering like ETFs with later maturity dates.

iShares is offering investment-grade municipal bond ETFs with bonds maturing in 2013-2017 (with a separate ETF for each target year).  Also, iShares has submitted documentation to the SEC regarding offering investment-grade corporate bond ETFs with bonds maturing, it seems, in April-March 2015-2016, 2017-2018, 2019-2020, and 2022-2023 (with a separate ETF for each target period).  The proposed expense ratio for some of the ETFs is 0.10%.  No proposed expense ratio was listed for the other ETFs.  (You can learn more about Guggenhiem and iShares’ defined maturity funds here.)

The existing and proposed shorter-term Guggenheim and iShares ETFs are not relatively attractive because CDs tend to be better investments from five years to maturity downward.  The existing, possible, and proposed longer-term ETFs are, or appear to be, relatively attractive.  Purchasing individual bonds may be less expensive enough to be better for you.  (There are markups on the purchase of individual bonds that are an important expense factor, and these markups are greater for smaller-dollar investors than they are for larger-dollar investors.)  However, these ETFs will very likely provide you with greater diversification, are easier to purchase than the many bonds required for proper diversification, and warrant less research and monitoring.  Also, it is possible to combine investing in these ETFs with individual bond and/or CD purchases.

There should be a continued trend toward the creation of more bond funds that hold bonds to maturity, and more investors should invest in these funds.  This is a smart direction for the bond fund industry and bond fund investors to head in.  Consider participating in this smart wave.

 

(3) Avoid U.S. Treasuries and Residential Mortgage Backed Securities (RMBSs)

U.S. QE entailed and entails the U.S. Federal Reserve buying U.S. Treasuries and RMBSs.  Not surprisingly, these are now among the priciest bonds available.  Also, RMBSs perform more poorly in a rising interest rate environment than they perform well in a falling interest rate environment.  This is due to phenomena known as prepayment risk and extension risk.

 

(4) Overweight Stocks, Underweight Bonds

The P/E (price/earnings) ratio for U.S. stocks is at about a historically average level, indicating stocks are about fairly priced.  Also, foreign stocks generally have lower P/E ratios; and, with interest rates as low as they are, stocks should be trading at much higher P/E ratios than is average.  (Note:  Holding foreign stocks involves currency risk.)  Regardless of how overpriced bonds currently are and how underpriced stocks currently are, for most people, bonds are still an important part of a retirement portfolio.

The following is a sample of a chart you can use to determine how much of your retirement portfolio to invest in stocks and how much of your retirement portfolio to invest in bonds (including CDs).  The chart assumes the oldest age you will live to is 110.  The bonds Underweight Execution % was calculated as of 2/22/13.  As interest rates rise and/or stocks become relatively pricier, the Underweight Execution % will become smaller.  At some points in history, the bonds Underweight Execution % is a stocks Underweight Execution %.  Different people calculate different figures for inclusion in tools like this, but the chart reflects some principles which are always applicable.  Bonds are more important as you age; you should only underweight or overweight bonds a certain amount; and it is usually better to underweight or overweight bonds, to varying degrees, depending upon bond and stock prices at the time.

Current Age

Balanced Portfolio

Maximum Bonds Under-weight %

Under-weight Execution %

Weighted Portfolio

Stocks %

Bonds %

Stocks %

Bonds %

0

100.00%

0.00%

0.00%

68.40%

100.00%

0.00%

10

90.91%

9.09%

8.26%

68.40%

96.56%

3.44%

20

81.82%

18.18%

14.88%

68.40%

91.99%

8.01%

30

72.73%

27.27%

19.83%

68.40%

86.29%

13.71%

40

63.64%

36.36%

23.14%

68.40%

79.46%

20.54%

50

54.55%

45.45%

24.79%

68.40%

71.50%

28.50%

60

45.45%

54.55%

24.79%

68.40%

62.41%

37.59%

70

36.36%

63.64%

23.14%

68.40%

52.19%

47.81%

80

27.27%

72.73%

19.83%

68.40%

40.84%

59.16%

90

18.18%

81.82%

14.88%

68.40%

28.36%

71.64%

100

9.09%

90.91%

8.26%

68.40%

14.74%

85.26%

110

0.00%

100.00%

0.00%

68.40%

0.00%

100.00%

If you are young enough to fall within about the first third of the chart above, at the present time, it is O.K. to own 100% stocks in your retirement portfolio.  Some investors are uncomfortable investing in stocks or investing a lot in stocks due to the greater price volatility.  If your retirement is or will be sufficiently pleasant without investing in stocks or investing a lot in stocks and investing in stocks or investing a lot in stocks will keep you from sleeping well at night or the like, it is O.K. to hold more bonds than the chart above, or one like it, suggests or, even, hold 100% in bonds.

 

Poor Strategies

There are some other strategies investors are using in response to low and rising interest rates that are ill-advised.  Some of these strategies are as follows.

 

(1) Buying Shorter-Term Bond Funds (That Do Not Hold Bonds to Maturity) in Place of Longer-Term Bond Funds

When interest rates rise, you will not lose as much principal in the shorter-term fund; but you will still lose principal.  Besides, you will receive a lower interest rate in the shorter-term fund than you would have in the longer-term fund.

 

(2) Buying Higher Dividend Stocks Instead of Bonds or Stocks in General

Higher dividend stocks have become very popular in recent years, so much so that they appear to be a poor purchase relative to other stocks.  There are a plethora of sources promoting dividend stock investing, and almost no sources promoting the opposite.  There are, now, 53 dividend stock ETPs (exchange-traded products).  None of these products are inverse funds, and there are no ETPs that focus on lower dividend stocks.  When too many people want to invest in the same thing, it becomes a relatively bad thing to invest in.  U.S. higher dividend stocks appear to have underperformed other U.S. stocks during about, at least, the last eight years.  The utility sector is the U.S. stock sector with the highest dividend rate.  The P/E ratio for the U.S. utility sector is, now, far too high given the earnings growth prospects for the sector, etc.

U.S. higher dividend stocks are not financially stronger than other U.S. stocks.  In fact, upon the last measurement I took, they were financially weaker.  U.S. higher dividend stocks declined about the same amount in price as other U.S. stocks during the last U.S. recession and U.S. financial crisis.  Higher dividend stocks are very much like other stocks, and they are not an appropriate substitute for fixed-income investments in a retirement portfolio.

If you are retired and your interest and dividend payments are less than what your spending amount for the year should be, use some capital gains and/or (stocks and/or fixed-income) principal to reach the appropriate spending amount.  Buying or holding currently relatively poor investments, as higher dividend stocks appear to be, will probably lead to you having less money to spend in retirement overall.  Buy and hold stocks in general, versus higher dividend stocks, to the extent you should be holding or desire to hold stocks.

 

(3) Buying Too Many Junk Bonds

Junk (non-investment-grade) bonds have higher and much more volatile default losses (of principal) associated with them.  You earn more in interest, but you lose more in principal.  In theory, at least, even with the greater default losses accounted for, you end up with a somewhat greater total return over the long haul with junk bonds because you were willing to accept more risk.

“Risk” is the key word here.  Regardless of whether interest rates are low or high at the time, there is a certain maximum percentage of junk bond investing that is appropriate in the fixed-income portion of your retirement portfolio.  The older you are, the less appropriate it is for you to hold junk bonds in your retirement portfolio; and the percentage of junk bonds it is appropriate for you to hold did not increase because interest rates fell.  If anything, this percentage decreased in proportion with the decrease in your fixed-income (versus stocks) allocation.

The price movements of corporate junk bonds are much more similar to the price movements of stocks, in comparison to the price movements of other bonds.  Also, with (U.S.) corporate junk bonds, you can swing from almost no default losses in a year to 20% or more default losses in a year.  In 2002, junk bond default losses were 11.51%.  This is not nearly the worst scenario that can occur, and corporate junk bonds are becoming junkier.

Historically, U.S. municipal junk bonds had far lower default losses than U.S. corporate junk bonds did.  One reason for this is that municipal bonds are often backed by an ability to increase taxes.  The future may not be the same as the past for municipal junk bonds though.

 

(4) Buying Commodities in Place of Bonds (or Stocks) in a Retirement Portfolio

Commodities are not investments.  They are speculations.  Less inflation, they are not designed to make a profit; and their price movements are more volatile.  There are many special factors that influence the prices of commodities; and, hence, they are not suitable for novice or typical investors.  They do not belong in a retirement portfolio.  If you are expert enough regarding one or more of them, you have a speculative portfolio in addition to your retirement portfolio, and you want to commit some of your speculative portfolio to commodities, it is, of course, O.K.

 

Mixed Strategies

At least one strategy for the current low and rising interest rates environment can be either good or poor, depending upon how you execute it.

 

(1) Buying Floating Rate Instruments

Floating rate notes have a floating interest rate, as do many senior loans.  The interest rates are tied to a benchmark rate, such as one of the Libor rates.  Usually, when the benchmark rate rises, the floating interest rate rises accordingly; when the benchmark rate falls, the floating interest rate falls accordingly.

Floating rate notes strongly tend to be short-term instruments.  Senior loans are intermediate-to-short-term, strongly tend to be non-investment-grade, and are often paid back prior to maturity.  This means that many of the floating rate offerings are competing against well-chosen 5-or-less-years-to-maturity CDs.  These CDs are, currently at least, better investments than like-maturity fixed-rate corporate bonds, and floating rate instrument yields are a little lower than yields for like fixed-rate instruments because the borrower is assuming the risk that interest rates will rise.  Also, the floating rates seem to always be tied to a one-year-or-less interest rate benchmark.  These very-short-term interest rates do not figure to increase a lot until about early 2015.

All of this said, floating rate instruments that are relatively longer-term and held to maturity or early payback could be a good investment.

 

Conclusion

All of the strategies used, or that can be used, in response to the current low and rising interest rates environment are not good strategies.  Be aware of which strategies will work or are likely to work and which strategies will not work or are unlikely to work.  Also, be aware of which strategies will  add unwarranted risk if used in your retirement portfolio.

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Comments

  1. Steve says

    Kurt,

    Are municipal bond funds going to share the same principal loss as Treasury funds?  I purchased ishares (MUB) to earn some yield on a chunk of our emergency fund cash, and I’m beginning to worry this was a bad idea. 

    • Kurt says

      Steve,
      Municipal funds like MUB will lose principal value too; but, in general at least, not as much as Treasury funds.  If interest rates return to where they were prior to the last U.S. recession and U.S. financial crisis in about 2017, you figure to lose about 0.5% per year overall in your investment in MUB up to mid-2017.

        • Kurt says

           Steve,
           
          To be clear, the “overall” includes interest payments you will receive, fund expenses as reflected in the fund expense ratio (0.25% per year), a very minor amount of estimated default losses (0.0066% per year), a capital loss due to interest rates rising, an assumed 15% tax write off on that capital loss, etc.  It’s not much off an overall loss, but it is still a loss.  Of course, this assumes that interest rates do “return to where they were prior to the last U.S. recession and U.S. financial crisis in about 2017”.

  2. Mark says

    Kurt,

    The Asset Allocation table you show is interesting and certainly looks reasonable but I’d be interested in knowing how you came up with it .  i.e. what is the mathematics behind it?

    • Kurt says

      Mark,
       
      Previously, I wrote an article that appeared on Seeking Alpha entitled “Your Retirement Investments: How to Overweight Stocks”.  Here (http://seekingalpha.com/article/938451-your-retirement-investments-how-to-overweight-stocks) is a link to the article.  It will answer a lot of your questions regarding how I came up with the table, particularly if you read my last Reply (dated 26 Oct 06:32 AM) beneath the article along with the article.

      • Mark says

        Thanks Kurt.  Interestingly, it approximates the formula age squared / 100 which I’ve tended to use.  e.g. at age 50, bond percentage would be 50 * 50 / 100 or 25% versus the .285 in your table.  The differences are largest at the extremes (and don’t work at all once you reach 100!)

  3. John says

    Kurt,

    Where would you place Preferred Stock in your list?  Would you consider an investment-grade issue, callable within the next 1-5 years, with a decent yield-to-call, as a proper substitute for individual bonds?

    Thanks!

    • Kurt says

      John, Preferred stock offerings vary in their makeup.  If the preferred stock can be converted into common stock and the price of the common stock is largely determining the price of the preferred stock, I’d categorize it as a stock for portfolio allocation purposes.  If the preferred stock’s price is largely being supported by a liquidation value (or par value) independent of the common stock value, I’d categorize it as a bond for portfolio allocation purposes.  The key question is:  “Beyond interest rates and the credit quality of the issuer, what is determining the value of the preferred stock?”  (Technically, preferred stock is equity versus debt.) The rating agencies tend to determine whether a preferred stock issue is investment-grade or not.  Preferred stock is rated as if it was bonds, but the ratings tend to be lower because payment of dividends or interest and principal is not as assured. Preferred stock tends to be perpetual; and the company can call it, but you can’t―unless you can convert it into common stock at a good price.  (Only some preferred stock issues are convertible into common stock.)  When interest rates rise largely, many preferred stock issues are going to fall significantly in price.  You can’t hold a perpetual issue to maturity because there is no maturity.  You can hold an individual bond to maturity, and thereby avoid taking a loss in principal value when interest rates rise.

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