Ideally, wealth creation would proceed on a path of steady growth. However, investment risks exist which require patience, conviction, and discipline in order for financial goals to be achieved. While stock market volatility is expected, bond investing is traditionally considered to be less risky. Ironically, a major investment challenge we currently are facing is the impact on bond investments in portfolios from rising interest rates in the months and years to come. As interest rates rise, the prices of high quality corporate bonds, U.S. government bonds, and municipal bonds fall.
The Federal Reserve (Fed), which sets the federal funds rate and the discount rate which both impact the rates at which money gets lent into the economy by banks, has announced that they will be raising short-term interest rates in the near future. The interest rate increases need to be done in conjunction with the Fed’s two mandates to help the economy reach maximum employment and 2% inflation. This week, the Fed met and decided not to begin the process of raising rates. Given their stated intentions, the Fed’s decision to not raise rates in September means the first increases will be coming later this year or in early 2016. The timing and amount of the rate increases will be based on the Fed’s assessment of the economy and a desire to not stymie economic growth while moving interest rates higher.
Due to the Fed’s pre-announcement of their rate raising goals, the investment markets reflect future higher rates. The reduced uncertainty about the future direction of interest rate changes may limit the negative outcomes for bond investments that often come with rising rates. The only uncertainties remaining are around the timing and magnitude of the interim changes on the way to a “normalized” federal funds rate of between 3.0% and 4.0% which the Fed believes can be reached by 2018.
Interestingly, the last five times that the Fed has raised short-term rates, the performance of short-term corporate and Treasury bonds has been positive. From June of 2004 through June of 2006, the Federal Reserve moved the short-term interest rates upward in small but regular increases from 1.00% to 4.25%. Because the increases were gradual and consistent, the investment returns for holding bonds were surprisingly good during this period of rising interest rates. Corporate bonds with one to three year maturities returned a positive 2.42%. Two-year U.S. Treasury bonds were up 1.51%. Even ten-year Treasury bonds, which are more interest rate sensitive than shorter term bonds, returned 1.87%. Following the interest rate increases, investors were able to earn higher returns from their bond investments which deliver most of their return in the form of interest income which is based on the interest rates.
While a core bond fund with high quality corporate bonds and U.S. Treasury bonds is a staple in any well-structured portfolio, it should not be the only approach to bond investing. In this current low rate environment, it is smart to have exposure to short-term bond funds that have demonstrated the ability to deliver positive returns in a rising rate environment. In addition, other types of bond funds have the potential to deliver positive returns in a rising interest rate environment. For example, high-yield bond funds generate their returns from lower credit quality bonds which are less sensitive to changes in interest rates but more sensitive to changes in the economy and the stock market. As long as the economy does not slide into a recession with many bankruptcies, high-yield bond funds should generate positive returns.
Another type of bond fund that benefits from rising interest rates is a floating rate securities fund. Floating rate securities include short-term bank loans to small businesses and bonds issued by large corporations that adjust the interest they pay based on current interest rates. As interest rates rise, the loans and bonds pay increasingly higher rates. Therefore, in a rising interest rate environment, investors in floating rate securities receive higher returns from their investments.
By diversifying our client bond investments into non-core bond funds, we believe our client portfolios are well structured to withstand the Federal Reserve’s controlled increase of short-term rates. The non-core bond funds add diversification benefits and provide for the opportunity to participate in higher returns when interest rates rise.
In the long-term, higher interest rates make bond investments more attractive and can make it easier to reach investment goals. While rates are rising, it is often an uncomfortable time to be invested in bonds. If portfolios are structured well, the impact of the rising rates can be offset by other factors. Our goal is for our bond investments to reflect the risks ahead and each client’s individual risk tolerance and investment return needs.
This update is intended for the use of Oak Wealth Advisors LLC clients. This update should not be viewed as personalized investment or financial planning advice from Oak Wealth Advisors LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their individual situation, they are encouraged to consult Oak Wealth Advisors LLC. Past performance does not guarantee future results and all investments should be scrutinized before being implemented in a portfolio.