Circumstances: The vast majority of economic data that has been released recently points to a domestic economy that has been improving, albeit at a modest pace. Consider that Initial Claims for Unemployment Benefits, a barometer of the health of the Labor Market, has come in at or near 300,000 for several months. That’s a number that, according to economists, signals a healthy labor market. Also, Continuing Claims along with the Duration of Unemployment continue to shrink while the housing market and housing prices (although not robust), have begun to rebound. With the above in mind, investors and consumers would be wise to consider the following.
Generally speaking, bonds and bond funds are inversely correlated to interest rates. As interest rates rise, the value of bonds decline and, as interest rates decline, the value of bonds rise. The bond market has been in a bull market since the early 1980s as interest rates on ten-year U.S. Treasury obligations have plummeted from nearly 18.00% to approximately 2.35%. Given that, in the future one would expect interest rates to stay flat, or more likely move up from current levels. Should this occur, the value of your bonds would decline. For example, let’s assume that you invest $20,000 in a U.S. Treasury Note that matures in ten years at the current interest rate of 2.35%. The interest of $235 ($20,000 times 2.35% divided by two) would be paid semi-annually for a total annual payment of $470. Let’s now assume that interest rates on the ten year U.S. Treasury Note move up to 3.80%, not an unlikely scenario given where it was less than five years ago. An investor at that time would receive $380 every six months or $760 per year as compared to your $235 per month or $470 per year. In addition to receiving less income than the latter investor, should you wish to sell the bond prior to its maturity date, you would receive less than what you paid.
1. Consider shortening up the average maturity date of your bond portfolio to less than ten years and, in conjunction with this, begin laddering that portfolio. Laddering consists of investing an equal amount over similar increments of time. For example, should you have a total of $100,000 to invest, place $20,000 in five separate bonds that mature in two, four, six, eight and ten years. Furthermore, once these bonds mature, purchase a ten-year bond, thereby keeping the “ladder” intact.
2. A second step to consider would be to refinance your mortgage debt now. Interest rates on home loans are at or near 50-year lows. There is much greater risk that they will head up substantially from here rather than continue downward. Also, if you refinance now and rates do continue downward, just refinance again if it is to your benefit.
3. Inflation is not a dirty word, especially after our economy has been flirting with a deflationary environment over the past five years. That said, with an improving economy comes a ratcheting up of demand relative to supply and therefore some upward (inflationary) pricing pressure on goods, services and hopefully wages. We would recommend, in order to offset the erosive impact of inflation on purchasing power, an investment into Treasury Inflation Protected Securities (TIPS). TIPS are offered by the Treasury Department and pay a nominal yield along with an added rate of return that is measured by the Consumer Price Index.
There you go–three steps you can take now in order to either protect yourself against rising interest rates or to benefit from them. Now get it done.
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security. Securities contain risks, and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor.
Please note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio.
To contact Fagan Associates, please call 279.1044.