“That’s great, it starts with an earthquake …..it’s the end of the world as we know it and I feel fine” R.E.M
Whether we like or not change is all around us. Whether we are talking about riots in the street, food shortages and price hikes, earthquakes and tsunamis or the expansion of my waist line, there are signs of change all around us. As Dylan sang “Times they are a changin’”. With the seismic shifts of late it seems that the world as we have known it is ending. Is it possible the Mayan prediction of the world ending in 2012 could have some merit? An end of certain societal patterns replaced with the birthing of new patterns as opposed to an outright Armageddon? Fitting, at least in a symbolic way.
Being our mandate is to educate and enlighten on topics dealing with financial markets and their effects on your money we will leave the discussions about Armageddon the Middle East and natural disasters up to experts more suited for such topics. Instead, we will focus on the more significant tectonic shifts seen in markets when interest rates rise and how you can possibly profit from the waves that may be created.
Since Reagan entered office (can you believe that was 30 years ago?) the financial markets have benefited from the tail wind produced by decreasing interest rates. For over 30 years individuals like you and I, as well as corporations have been paying less and less interest to borrow money for the purchase of homes, cars and businesses. In return, banks have been paying us less and less for savings entrusted at their institutions. For example, I remember riding my Huffy down to Home Savings in Lake Forest Ca in 1979 to open my first bank account that paid over 9% interest! That same night I watched my parents celebrate that they were able to get a home loan for under 13%. Could you imagine how much your house payment would be if you were paying 13% interest on your mortgage? Luckily, you don’t have to imagine as we did some calculations to keep you entertained. As it turns out, if you have a mortgage of $300,000 and were paying the rate my parents popped a bottle of bubbly over your payments would be $3,318 a month, a bit more than the $1610 it would cost you at today’s rates. To have your own fun check out our loan calculator.
Back to the point, thirty years of declining rates has added a lot of fundamental fuel to the world economy. Now, we sit at a cross-roads. Hence, the end of the world as we know it. Which, at this moment, looks like the same road my grandparents took to school. Up hill both ways in the snow. In other words – a strong argument can be made that all roads lead to higher interest rates. Bill Gross of PIMCO could be onto something when he stated we may be at the very beginnings of a generational shift in interest rates. Which means that if you are over the age of 60 you may never see rates as low as they are now again. I say that with the greatest respect as I witness my own personal generational shift of deflation in the shoulders and inflation in the mid section.
In the event this is true and we are at the forefront of years in increasing rates, what are the implications for your nest egg? For one, rising rates increases volatility in financial markets. Why? You ask. One reason is interest rates have an effect on liquidity within markets and liquidity has an effect on volatility. As rates decrease liquidity increases which leads to a decrease within volatility. As interest rates rise liquidity contracts and volatility picks up. While this creates opportunities for some it also causes some restless nights for the risk averse investor. Outside of volatility, rising rates can have a direct impact on certain asset classes. Good for some, not so good for others.
The Winners and Losers of Rising Rates.
We will start with the assets that will most likely have the greatest struggle if and when rates rise. The first and foremost would be bonds. It’s no secret that rising rates create a direct headwind on the price of bonds. Here are some examples from Martin Weiss on how rising rates have had an effect on bond prices in the past.
From June 1979 to February 1980 the yield on the 30 year moved from 8.9% to 12.6% creating a 10% decline in bond prices according to Weiss research. That’s not all….
From Sept 1993 to November 1994 bond prices declined more than 21% as rates moved from 5.19% to 8.13%. So much for the low risk – safe haven of bonds if your timing is off. Now you might be looking at those dates saying “yeah, but that was then, this is now” . For those readers, I offer the 30 point decline in treasury bonds from December 2008 to June 2009 as interest rates on the 30 year treasury went from 2.5% to 4.8%. In fact, if we returned to pre-crises levels of interest rates the 30 year could rise to 5-6% which could be a decline of 14-17% in prices from today’s levels and that would only get interest rates back to where we were in 2007.
Needless to say those with bonds in their portfolio should be doing some serious thinking about what they may do in the next few years.
In addition to bonds, rising rates tend to put a pinch on any corporations which rely upon greater amounts of debt to help finance their operations. The usual suspects in this arena would be utilities.
So what is an investor to do if they are seeking lower risk options that pay income and the “widow and orphan” stocks are challenged at a time of increasing volatility. Luckily, there are always two sides to every coin and as part of the mantra “problems create opportunities” we find the opportunities by flipping the weaknesses noted above and focus our attention on assets that may have potential tail winds in a rising rates environment.
Advancements in exchange traded funds as well as Index Linked CD’s now make it possible for individual investors to earn returns when interest rates rise. In the vast majority these investment are termed “rising rates” or “bearish treasury”. The bottom line is they can be used as a way to balance or hedge a portfolio of bonds so an investor can collect income while potentially mitigating the decline in bond prices. With proper design and diversification it could be possible to create current income and maintain overall net worth in the event rates rise.
Tactical management is another approach an investor can decide to take. With the advancement of the products just mentioned there are fund managers who specialize in tactical management within the bond market. They use a series of technical and fundamental analysis to adjust an income portfolio from treasuries to corporate bonds to high yields or even rising rates funds as the markets wax and wean. There are some good managers with good track records worth looking at, feel free to contact us for a list of managers that provide this type of service.
In addition to tactical management and rising rates there is also the good old commodity trade which seems to be top of many conversations as Silver and Gold push higher in recent weeks. It is important to note that commodities have never been a safe haven for low risk investors and there is an inherent risk and high levels of volatility within commodity markets. Definitely not for the faint at heart. Regardless, for those that have a skill set of knowing how to manage risk, commodities can offer some potential. You should join us April 29th in Irvine CA where we will discuss risk management within inflationary markets. For more information click here.
That is all the time we have for now. We look forward to seeing you on April 29th if you decide to join us. If you would like a detailed list of investments and management styles that may do well during inflationary times contact our office at 949-492-6900 or firstname.lastname@example.org and we will be happy to discuss.
*The opinions expressed are those of Quiver Financial as of 4-19-11 and are subject to change due to market and other conditions. Any investments mentioned are not recommendation and you should always discuss any ideas mentioned with your financial advisor. Past performance is not a guarantee of future results.
Securities and Investment Advice are offered through Newport Coast Securities, an SEC-registered Investment Advisor and Broker Dealer member FINRA/SIPC.” This material should not be considered as an offer to buy or as solicitation of an offer to sell any securities. Recommendations can only be made with review of prospective client portfolio by request. Past performance is not a guarantee of future results.