As an investor, you should run your household finances like a CEO should run a corporation. You are solely responsible for making the financial decisions that should put you in the best position. Currently, corporations are issuing corporate bonds at 2.5% interest rates for 10 years. The reason behind the bonds is twofold. First, demand: U.S. Treasury bonds are yielding considerably less, with the 10-year bonds yielding around 1.8%. Therefore, investors are willing to take the increased risk of a corporate bond to get the increased yield. Second: Companies expect interest rates to increase, so they are preparing for the future by borrowing long-term money now at dirt cheap rates.
As your household’s CEO and with money as cheap as it is, you have to consider how to make a similar move. This is why we have stressed the importance of locking in your mortgage at these historically low rates. If you are able to lock in a 30-year mortgage at less than 4%, and you are able to deduct the mortgage interest in your taxes, the effective cost for borrowing is very cheap.
In the last month, corporate, investment grade bonds sold yielded an all-time low interest rate of 3.2% on average. Over the past 30 years, however, those same bonds averaged a yield of a little more than 7%. That is a 400 basis point differential. If borrowing costs are too good for corporations to pass up, investors should take note. To us, this indicates that corporations believe interest rates will rise.
When interest rates increase, the bond you bought when interest rates were low is worth less because new bonds offering higher interest rates are available. Thus, when interest rates rise, bond prices fall. Likewise, when interest rates go down, bond prices increase. Bonds with longer maturities, generally, offer higher yields, but also have the potential for greater price swings than those of shorter maturities.
The average investor does not want to buy McDonalds Corp. (NYSE: MCD) today for fear the stock market might swing, and you might lose your principal. However, if you have a bond paying 2% in interest, and interest rates increase to 4%, your principal value of the bond could easily drop 20%. If you hold the bond to maturity, your principal is generally safe. However, if you are forced to sell the bond before it matures, your interest rate risk is just as detrimental as market risk is for common stocks.
Additionally, you have inflation risk. Consider that you purchased a three-year corporate bond yielding 0.8%. The annualized inflation rate through June 30, 2012 is 1.7%. That three-year bond guarantees you nearly a 1% loss, thanks to inflation.
Bonds are usually safe in one sense—preserving your principal when held to maturity. A 1.8% interest rate on a 10-year bond is not very compelling, but if it is money you will need in the next 10 years, you cannot afford to take the risk of equities. You have to park the money somewhere, and bonds are a solid choice for short-term needs. However, if it is long-term money you are investing, you should look at the growth aspect the equity markets provide.
At Henssler Financial we believe you should Live Ready, which includes understanding the interest rate risk of your “safe” investments. If you have questions on how to mitigate interest rate risk, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
