Interest rates are a part of our everyday lives. Interest is the price we pay for the use of money we borrow from a lender expressed as a percentage. We pay interest on credit cards, home mortgages and auto loans, while we receive interest on savings accounts, certificates of deposit (CDs) and bond investments. You may ask, “How does this affect me?” When interest rates rise, the cost of borrowing money increases. When they fall, the cost of borrowing becomes cheaper. There are many factors that determine interest rates, but they are mostly based on the Federal Reserve Bank and its monetary policy.
For nearly two years, U.S. interest rates have remained at unprecedented lows as a result of the collapse of the housing market and the ensuing economic downturn. The Fed has managed rates between 0.0% and 0.25% to help businesses and asset values recover, and to encourage growth in our economy. However, economic growth is beginning to spur inflationary pressures, which is common. Other countries have begun to ratchet up interest rates to fend them off. The People’s Bank of China has raised interest rates four times in the past year, with the most recent rate hike as of April 5, 2011. Inflation grew in China at a rate of 5% in the first quarter of 2011. The European Central Bank raised its interest rates on April 7th. Again, inflation was the reason cited for the increase. In the United States, prices for some goods have begun to rise. The Fed has maintained that domestic inflationary pressures remain low and that rate increases are not yet justified. Continued declines in housing prices and high unemployment are their strongest argument. Eventually, our modest recovery will gain enough steam to convince Fed Chairman Ben Bernanke that the recovery is sustainable without government intervention. When that happens, interest rates will be raised. Either way, it will affect you and your investments. Here are a few thoughts and strategies to help you prepare for the impending rate increase.
Consumers
Consumers are affected in many ways when interest rates rise. As stated before, when rates rise, borrowing expenses rise. The interest charged on credit card balances is immediately steeper after a rate increase. Financing a home or auto consumes more of our monthly income than in previous months. If you are considering the purchase of a home, you will pay a lot more in the long term for a house, with just a slightly higher interest rate loan. However, real estate prices have not reached a bottom, and nobody knows how low prices will eventually fall.
Strategies:
Refinance Now: If you have a home mortgage and are waiting for the lowest rate possible, consider that rates remain near historic lows and are more likely to increase than decrease. In fact, we have seen rates increase in anticipation of the coming Fed actions. Since November 2010, Freddie Mac Primary Mortgage Market Survey rates have risen from 4.23% to 4.84% on 30-year fixed rate mortgages. Meaning, we may have seen the bottom of home mortgage rates. Therefore, consider a refinance now. We strongly suggest that you pay down your card balances.
Consider Making Large Purchases Now: If you are planning a large financed purchase in the near future, consider the benefits of doing it now rather than waiting. The lower rates may save you enough to justify the early purchase.
Bonds
Bonds are the contracts companies and governments use to borrow money. They can often benefit their holders by providing steady, reliable income and reducing portfolio volatility. Many investors, who are still stinging from the recessionary declines in stock values, hold more bonds than they should. This is unfortunate, as their fears have caused them to miss a significant stock market rally dating back to March 2009. However, the second phase of a potential loss is lurking in the coming increase in interest rates. As interest rates increase, bond prices move lower to provide market level rates to potential buyers. Recall our earlier discussion of the reason for rising interest rates was to slow price inflation. High inflation eats away the purchasing power of currency. Consider what happens to a fixed bond yield when inflation increases. Investors consider the yield in excess of inflation the real yield—as inflation rises, the real yield falls. This anticipation of loss leads many to sell their direct holdings in bonds and bond funds, which generally happens in anticipation of inflation and interest rate increases.
However, there are many reasons to hold bonds even in these times. An investor with a significant fear of principal loss may remain comfortable with holding bonds for their lower volatility, knowing they will receive a set amount at maturity as long as the issuer of the bond stays solvent. Others may wish to hold bonds to provide for future spending needs, again avoiding the more volatile stock market.
Strategies:
Keep Maturities Short: For bond investors, we recommend keeping maturities short term, in the one- to three-year range. Longer maturity bonds, such as 10-year or 30-year bonds, are more sensitive to interest rate changes. An increase in rates will cause their price to move lower at a more rapid pace. Falling rates, on the other hand, will increase their price more. Therefore, when you buy bonds in times when interest rates are expected to increase, keep maturities short.
Consider Bonds with Large Coupons: Oddly enough, low coupons also give bonds more sensitivity to interest rates. We suggest bonds with large coupons and short maturities should be sought in these times.
Cautiously Consider TIPS: Other securities like Treasury Inflation Protected Securities (TIPS) may provide some benefit, but caution should be exercised as prices of TIPS often adjust in anticipation of inflation. The concern is that high demand in these times can drive TIPS prices too high, and thus, purchasers can experience underperformance relative to non-inflation adjusting bonds.
Equities
Those who have not lived under a rock for the past 18 months know stocks have rewarded their owners quite handsomely during that time period. The Federal Reserve’s economic stimulations, bailouts, low interest rates and quantitative easing have been making a difference in stock prices—just as designed. This growth, strangely enough, can be a negative if gone unchecked. The feared price inflation can ultimately deteriorate purchasing power to the point that even strong growth is outpaced by the falling value of the currency. However, until that eventuality, businesses feed off low interest borrowing and enjoy the high profit margins and earnings growth low rates beget.
So what happens when rates increase? Well, the so-called “removal of the punch bowl”—i.e., end of the stimulus—makes borrowing more expensive. Profit margins narrow, corporate earnings grow more slowly, as does the economy. However, it is very uncommon for the managers of our economy to act in perfect time to keep inflation fully in check. Inflation likely will rise above targets set by The Federal Reserve.
Strategies:
Invest in Companies that can Pass Inflation to Consumers: Inflation is not necessarily bad for stockholders, as companies are generally able to fully pass along price increases to their end-users over a five- to seven-year period. However, those who are able to pass inflation along more quickly, such as Consumer Staples, can provide better performance in the short term.
Bottom Line:
With the Federal Reserve holding short-term rates near 0% for the past two years, it is a sure thing interest rates will go nowhere but up. The question of timing still remains, but looking at recent signs of economic growth, we believe now is the time to take action for that eventuality. Securing low interest rates on your loans where possible, paying down short-term debt and keeping fixed-income investments short in duration are among several items to review in your personal finances. In our opinion, the main focus in your investment portfolio during times of rising interest rates should be on stocks.
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.
