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Questions About Rising Interest Rates

Posted: Brandon Arns

Although most of the focus has been on stocks lately, it is bonds that have arguably had the more interesting year. Interest rates (which we will use the 10-year treasury yield to represent) have been climbing rapidly, starting the year from about 0.9% to 1.52% today. This often neglected number is extremely important. It represents the cost of money. Where the 10-year rate sits influences the rate you get on your mortgage or car note. It represents the markets views on growth and inflation. And of course, it determines the return you receive on your bond investments.

Below are some of the most important questions regarding interest rates.

Why are they going up?

Interests rates typically represent the market’s expectations for inflation. For the last decade, inflation has been very low, rarely going over 2%, but it is easy to form a narrative for why that might be changing. Most common explanations are:

  • High level of government spending
  • Supply chains disrupted due to the pandemic (semiconductor shortage may be the biggest story here)
  • High level of demand returning once the majority of the population gets the vaccine and things return to “normal” (travel returns, retail and restaurant spending, etc.)

Is inflation bad?

Usually when you hear about inflation, it is described as a very negative thing, and it can be. How bad it is really depends on the type of inflation we get, how dramatic the rise is and how long it lasts.

For example, if we start to get inflation because things go back to normal, people get their jobs back and start spending money with all the pent-up demand, that could be a great thing. This inflation is demand driven and is something that can likely be controlled.

Another type of inflation is supply driven inflation. The US imports a lot of goods from other countries, usually because its cheaper than making them here. However, if due to the pandemic there are travel restrictions, or a virus outbreak causes workers at a factory to have to stay home, it may be more difficult to get the goods here. This will cause their price to go up as they become more difficult to acquire.

Some combination of those two types of inflation is likely what we are going to experience here in the US. If this is the case, it should not last for too long and is manageable.

On the other hand, if all the government spending leads to a loss of confidence in the value of the US dollar relative to the rest of the world, that would be bad. This is the type of inflation you will hear about in gold commercials and doomsday preppers. It’s far less likely to occur, but the result is much worse.

How do interest rates affect my bond portfolio?

There are two sources of return for bonds: income and price appreciation. The income side of the equation is simple. Whatever the stated yield of that bond, that is how much income you should expect to earn. So, if you buy a 10-year treasury bond today with a coupon rate of 1.5%, you should expect to earn 1.5% every year until it matures.

Although the bond that you own may have an interest rate of 1.5%, the market’s interest rate is constantly fluctuating. As the markets yield goes up, the value of the bond you currently hold goes down, and vice-versa. This makes intuitive sense. If you own the 1.5% yielding bond in the previous example, and the market rate goes to 2%, the bond you own is not as attractive anymore. So, to sell it you’d have to offer it at a lower value.

This year for example, as interest rates have moved up a little over 0.5%, a 10-year treasury bond has lost about 5% of its value.

Can bonds still protect my portfolio?

Most investors use bonds to protect their portfolio from more volatile stock investments. Historically, bonds have been fantastic for this. Not only have they given a solid yield of 5%+ per year, they historically have increased in value during bad stock market crashes, which helped buffer the portfolio’s losses.

One of our biggest concerns managing money is whether or not bonds will continue to be able to offer that protection. We call this “the bond problem.” In the past, whenever a recession would occur, bond yields had a pretty good margin to fall. In 2008, for example, the 10-year rate fell from over 5% to about 2%. Today we sit at about 1.5%. So, if we assume that rates cannot fall below 0%, then we do not have very far to go. As a result, bonds do not have the same protective properties they used to.

What else can you buy to protect the portfolio?

In traditional assets, there are not many options. You can hold cash, but of course today that yields about 0%. You can buy gold, but gold itself is very volatile and not guaranteed to go up when markets are volatile. You can simply hold less stock, but while this will make your portfolio less risky, it may not generate returns high enough long term to accomplish your goals.

Because of this, we’ve worked very hard to try and identify alternative asset classes and strategies that can potentially make a satisfactory return without adding more risk to the portfolio. These can be tactical strategies that reduce risk when volatility increases, alternative forms of income, and unique sources of risk that have nothing to do with the growth of the economy or interest rates. These are strategies we actively allocate to at WJ. If you would like to learn more about these, please give us a call.

Can rising interest rates affect my stock investments?

This is a critical question. Even if your portfolio does not hold much weight in bonds, rising interest rates can still have a significant affect on your stock investments. Keep in mind that most companies, especially young companies, rely on debt to grow. If the borrowing rate at which those companies finance projects or operations rises materially, it can have a large impact on their profitability.

In addition, investors have been overweight in stocks for many years simply because bonds do not produce the level of return needed. If rates were to rise to a high enough level where bonds became more attractive, investors may shift some of that money out of stocks and back into bonds, causing stocks to fall.

Please contact us if you would like to discuss the impact of rising interest rates on your portfolio.

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