Gil’s Musings

Interest Rate Worries

In recent weeks, speculation has grown that the Federal Reserve will increase interest rates by the middle of next year, prompting some investors to re-assess their strategies for low-interest-rate environments. It’s far too early, though, for U.S. investors to panic over rising rates.

For one thing, the weak August jobs report, released on Friday, is the kind of economic news that could cause the Fed to delay any action on rates.

But even if the Fed does decide to act next year, it’s important to maintain a sense of perspective. At the moment cash is paying zero and 30-year Treasuries are yielding 3.5%. Rates, in other words, have a lot of room to move before investors need to rethink their strategy.

Many pundits argue that the short-term bonds are the riskiest because they have the most ground to cover when rates begin rising. But they were saying the same thing three years ago. If investors followed this advice, they missed the yields achieved by extending maturities.

Rates for short-term bonds, those maturing in one to five years, certainly need to move the most, but again, some perspective is warranted. Their short duration makes them the least sensitive to price changes.

Keep in mind that while the Fed may take action sometime next year, rate increases are going to be incremental. Each day that passes, every four-year bond loses another day of duration.

In this environment, it’s not unusual for investors’ trigger fingers to get itchy. Those who own bond funds often get caught in the investment equivalent of musical chairs – they stay in a fund paying 5% for as long as possible, then try to sell before the music stops and rates rise. This is a dangerous game.

As I wrote recently, individual bonds only go underwater until their maturity date, which gets closer with each passing day. In other words, if you buy individual bonds, your risk from rising rates diminishes daily.

The best strategy as we wait on the Fed is to buy individual bonds with longer short maturities – three to five years – or a shorter intermediate duration – five to seven years. This will pay much higher yields than sitting on cash and waiting, and a sudden jump in rates, if and when it comes, will only hurt for the residual time left on the individual bond.

High quality bonds of this nature won’t pay the 5% offered by many funds, of course, but it’s worth noting that many fund distributions are an illusion. Funds distribute whatever amount they want, regardless of the earnings. That 5% yield they promise could actually be your principal. Don’t be deceived by promises of higher yields. In this environment, it’s better to take a bit less yield to know that you’ll still have a seat when the music stops.

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