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 under 400,000 for seventeen consecutive weeks, a number that, according to economists, represents the demarcation line between a growing and contracting labor market. Furthermore, Continuing Claims along with the Duration of Unemployment continues to shrink while the housing market along with housing prices although not robust, have at least stabilized. 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 move up the value of bonds go down and as interest rates move down the value of bonds go up. Given the fact that the bond market has been in a bull market since the early 1980’s as interest rates on U.S. Treasury obligations have plummeted from nearly twenty percent to approximately three percent, in the future one would expect interest rates to stay flat, or more likely to 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 2.30%. The interest of $230 ($20,000 times 2.30% divided by two) would be paid semi-annually for a total annual payment of $460. Let us now assume that interest rates on the ten-year U.S. Treasury Note moves up to 3.80%, not an unlikely scenario given the fact that is 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 $230 per month or $460 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.
Our recommendation would be to consider shortening up the average maturity date of your bond portfolio to less than ten-years and in conjunction with this, beginning 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.
A second step to consider would be to refinance your mortgage debt now. Interest rates on home loans are at or near fifty 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.
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 that in order to offset the erosionary 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.