Investments to avoid when interest rates rise

We proactively seek out the best investment vehicles for our clients’ portfolios. To spur new sales, Wall Street is constantly creating new products or repackaging existing ones, so our search is ongoing. Sometimes their products are useful innovations but most of the time that is not the case, such as in the bond market.

Our view is that suffering significant losses in the bond market when rates rise is an avoidable outcome. Not all bonds are created equal.

Since interest rates have been low for the past few years, there has been much chatter in the press about how rates must rise. When rates rise, the price of bonds fall so all the chatter has made people nervous. Our view is that suffering significant losses in the bond market when rates rise is an avoidable outcome. Not all bonds are created equal. We want the bond portion of client portfolios to be far more stable than stocks. This serves as a counterbalance to the notorious ups and downs of the world’s stock markets. As a result, we have always favored short to intermediate term bonds of high credit quality. These holdings will fluctuate in value but history shows clearly they are far more stable than long term bonds and junk bonds. (You may not see the term “junk bonds” much anymore. Wall Street changed the packaging on those years ago and now calls them “high yield” bonds.)

We would like to share some of what our research determined when looking at products that are marketed as being “good” in a rising rate environment. These are floating-rate loans, high yield bonds, and short term bonds which react like long term bonds.

Floating-rate loans could sink

Specifically marketed as protection from rising rates are mutual funds and exchange traded funds that own “floating-rate loans”, also called “leveraged-loan” or “bank loan” funds. Typically, these loans are made by banks to companies in weak financial condition or with poor credit ratings. The interest rates on most of these loans adjust, or “float” up or down every one to three months. The sales pitch is that when rates rise, these adjustments could increase the income from the loans. A closer examination reveals at least two devils in the details.

First, in most cases, the loan interest does not increase in lock step with interest rates. Rates have to rise by a specified minimum amount before the loan’s interest rate changes. Further, when the increase is triggered, it is often limited to a specific amount.

The second devil reveals itself for loans without such limitations. Remember, these loans are made to financially stressed entities – companies in weak financial condition with weak credit ratings. Investors only get paid if the borrowers make the payments. Without a limit on the potential increase, the stressed company can find itself under even more stress as its interest expense increases quickly. Many of these loans have, in fact, defaulted with an uptick in rates. Accordingly, these loans tend to be sensitive to economic issues much like stocks.

How did floating-rate loans do during significant economic stress? Lousy. The S&P/LSTA U.S. Leveraged Loan 100 Index lost 28% in 2008. Several short term bond funds had invested in more conventional securities but from companies with poor credit. Many of these suffered as well. If you were trying to eke out a little more interest, you paid dearly. Those losses are a reflection of what credit risk can yield.

“High-yield” is Wall Street’s name for “junk” bonds

Junk, now known as high yield, bonds pay more interest precisely because there is greater doubt the companies will actually make their payments. The financial crisis showed the effect of this credit risk. In 2008, the S&P 500 index of the stocks of large U.S. companies dropped 37% and the category average for high yield bond funds tracked by Morningstar fell nearly 30%.  In contrast, traditional bonds with good credit posted gains, offsetting the decline in stocks just as we wanted them to do.

We prefer short term, high credit quality bonds because they are more stable. There is a high probability of getting paid on time and if interest rates rise, the short term bonds mature and can be invested at the higher rates in new bonds from other high quality entities that are likely to pay on time and in full.

Short term may be longer than you think

But it is not as simple as just buying any short term bond or bond fund. Some funds are playing games which can hurt investors. In addition to using junk bonds, we have found a number of funds which have large amounts of callable bonds labeled as “short term” but are likely to react like long term bonds whenever rates rise. Long term bonds fare poorly when rates rise due to a measure known as “effective duration,” a bond’s sensitivity to interest rate changes. Short duration bonds should experience low price declines when rates rise.

Callable bonds can be redeemed by the issuer prior to maturity. When interest rates decline, the chances of a call are higher and the duration calculation results in a shorter duration. By stuffing a fund with some callable bonds with maturity dates far in the future, the fund can tout a higher yield and still be categorized as short term. When rates rise however, these securities can act like the longer term bond that comes due at the maturity date on the bond.

The financial media has been predicting a rise in rates for the last six years and eventually, rates will rise. The rise may have already started. Janet Yellen and the Federal Reserve have not increased rates and probably won’t for several months. The Fed doesn’t control the rates that affect your investments, the market does. As of June 30, 2015, the yield on the 10-year U.S. Treasury rose .67% since its low point for the year back in February.

Pundits won’t help you

If you knew rates had gone up before reading this, chances are you heard about it from the media because good quality short term bond holdings are so stable there simply has not been a significant price decline which would tip you off that market rates went up. The individual securities, mutual funds, and exchange traded funds (ETFs) we favor for bond holdings are designed to avoid large losses on rising rates.

If you are listening to pundits, you could be unnecessarily worried. In early June for instance, one outlet dubbed the move in the 10-year bond “dramatic.” The discussion said this must be due to the market anticipating the Fed moves. Pundits also said this is the capitulation point for bonds and predicted a massive sell off and catastrophic losses in bonds. As purported evidence, they offered this tidbit. On June 3 and 4, the 10-year rate closed above 2.30% for the first time this year, as though 2.3% is some sort of magic number.

If you are listening to pundits, you could be unnecessarily worried.

Being curious as well as discerning, Mike Salmon, a CFP® professional with our firm, looked into what magic 2.3% might possess. As we suspected, there was none. The 10-year bond was above 2.3% on 214 days in 2014 and 134 days in 2013. Yet there was no capitulation, massive sell off, nor was there any significant losses among short to intermediate term bonds of high credit quality.

Wall Street and fund companies know that most people buy funds based on hot recent performance and the yield stated by the fund. This creates an incentive to use bonds with longer maturities or weak credit profiles. We are more discerning. We are also too disciplined, diversified, and patient to be deluded into thinking interest rate movements can be predicted with enough precision to profit by timing the bond markets.

Below are links to recommended reading for more information:

INTEREST RATES UP, BONDS DOWN, NOW WHAT?

HOW WILL RISING INTEREST RATES AFFECT YOUR INVESTMENTS?

FOR SUCCESSFUL INVESTING, CONTROL YOUR INTAKE OF BUSINESS NEWS

News & Notes

Community impact: Charlie Fitzgerald III, CFP® presented a seminar, “Don’t Be a Fool With Your Personal Finances” to Barry University Alumni on April 1st. Charlie covered a wide range of topics and answered a host of questions during the session. The outline is available upon request. Our firm often speaks to civic groups and clubs in Central Florida for free as a service to the community. If a group you know about needs a speaker, we would be happy to design a program of appropriate content and length.

Strynchuk keynotes Estate Planning Council meeting: Lynne Strynchuk, CFP®, CDFA™ presented, “The ‘D’ Word: The Effects of Divorce on Financial Planning” to the Brevard County Estate Planning Council. The BCEPC is the only professional association in Brevard County for Estate Planning professionals and provides members (attorneys, accountants, and advisors) a forum for education, networking, and exchange of ideas. Lynne holds the Certified Divorce Financial Analyst and provides unbiased financial advice to divorcees, people in the process of divorcing, and attorneys representing a spouse in a divorce matter.

Please remember to call us: When anything significant happens in your life, including changes in your finances, family, or health that could affect your financial plan, please let us know so that we can adapt our planning and portfolio work for you accordingly. Also, if you ever fail to receive a monthly statement for one of the Schwab Institutional or TD Ameritrade Institutional accounts under our management, please let us know so we may assure the respective custodian delivers your statements promptly.

Yours truly,

The Team at Moisand Fitzgerald Tamayo, LLC

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