Interest Rates and the Federal Reserve

fedreserveJuly 26-27th was the last FOMC meeting and it ended with the board choosing not to raise interest rates again. In the press release following the announcement the Fed stated they would consider raising rates in the September 20-21st meeting. This has prompted plenty of discussion by the investment community on the validity or actuality of this taking place. Needless to say we have heard this song before with a different tune. For investors it creates that age old dilemma of waiting on the Fed to act. Why the dilemma? We all understand if interest rates rise the value of bonds decline. Therefore, many are now waiting for rates to rise… because If we wait for rates to rise, the benefit to us, the investors, is getting a higher yield without the immediate risk of the bond value declining. But, what if rates don’t rise in September? With money market accounts earning effectively zero you can see the disadvantage of timing interest rates.

The Fed has been like “the little boy who cried wolf” the last several years as it continues to push the thought of hiking interest rates short term. With rates effectively at zero any upside would be a welcomed opportunity for fixed income investors as it relates to the higher income stream created. Timing or predicting interest rates tends a losing proposition for investors as they are usually wrong in their predictions. That said, if the Fed does engage in the activity of raising rates, the short term pain will be offset by the longer term gains. So don’t look at rate hikes as an all negative proposition if you are an income investor.

As it pertains to the issue of the rate hikes destroying your money the Fed is more transparent than some would have you believe. There is plenty of warning from the Fed relative to their intention with rates allowing investors the opportunity to reallocate money or raise their cash position. Money management is not about timing markets, but managing the risk of the markets by sector or asset class.

Income investors are attracted to bonds for the predictable income and simple risk management if the bond is held to maturity. But, when interest rates start to rise several things materialize in the income investors’ minds. First, they worry about losing money or the value of the bond dropping. If the bond is held to maturity the investor receives his or her investment back fully intact. For example, you buy ten one thousand dollar bonds yielding three percent for ten years. If rates rise to four percent, the value of the bond drops in the open market should the investor wish to trade or sell the bond. But, if the investor holds the bonds for the entire ten-year period you will receive your one thousand dollars back. Thus, the risk of the bond is if you need to liquidate or sell the bond before maturity.

Second, fear of missing out or the grass is greener syndrome. As yields rise it is human nature to want to have the higher rates or yields in our portfolio. This is where we are tempted to sell the lower yielding bonds and buy the new higher yielding bonds. This is not always the best course of action and we have to manage our expectations and emotions. Holding or waiting to maturity could be the better option. The key is to always define your objective prior to purchasing any investment and then managing the risk of the investment as time advances.

One way to deal with the risk of rising rates is through a simple strategy of laddering bonds based on duration, ratings and yield. The additional benefit would be you always have bonds maturing to allow you to take advantage of rising rates. It could equally be a disadvantage when rates are declining as you would be buying lower yielding bonds. The best feature is you create rolling liquidity to your portfolio to meet any needs should they arise. As you can see the key is to have a defined strategy, objective and risk tolerance before building your income portfolio.

The challenge of listening to the pundits and talking heads about interest rates is the misconception that rates rise and fall quickly. That is simply not the case 95% of the time. There is always the outlying risk of a 2007 when the banks, consumers and investors are over extended and react in a panic versus an orderly manner. When evaluating the risk of the Federal Reserve raising interest rates take into account they generally act in one quarter of a percent increments over extended periods of time. That gives you and me as investors time to reallocate our portfolio according to the risk associated with the action taken by the Fed. Patience is key when you are an income investor.

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