Section 4.3

Fundamentals of Market Investing by Adam J. McKee

 Interest Rates

As anyone who has ever put money into a savings account would expect, interest rates are an important concern for investors.  When you invest in bank accounts, CDs, and other cash instruments, the interest rate determines your return.  Since the financial crisis in 2008, the interest rate has been near zero.  This makes money cheap for both individuals and businesses, and they can better spend on things that will create value.  This is good for consumers and businesses alike, individuals can afford more expensive homes and automobiles.  Businesses can grow and expand.

In the United States, the Federal Open Market Committee (FOMC), a body within the Federal Reserve, sets the government rate.  When the economy is stagnant, and recession is looming, the FOMC can vote to cut rates and give the economy a boost.  When the economy is “running too hot,” and inflation is looming, the Fed can raise rates and slow things down.  This is the primary tool the Fed uses to accomplish its dual mandate of economic stability and high employment.  Needless to say, when the FOMC talks, Wall Street listens.

Low rates are great for stockholders.  A major reason for this is that cheap money means that businesses can realize more profit and thus margins can expand.  Another theory holds that if interest rates are very low (e.g., lower than inflation) then investors have no option but to invest in stocks since nothing else is paying a decent return.  When bonds are sold to the public, they generally have a fixed interest rate that represents the federal funds rate plus a premium for risk.

Bonds bought in times of very low-interest rates will not pay a very good rate.  As I write this in early 2018, the Fed has said that it will begin to normalize interest rates by hiking rates 25 basis points each quarter over the next several years.  The effect is volatility in the stock market as investors try to decide if higher rates should devalue stocks while at the same time the economy is doing very well, GDP is growing, and unemployment is very low.  Bulls say that the economy is doing so well that stocks should be able to maintain their high valuations.  Bears say that when interest rates rise, stock prices will fall and you had better be ready for it.

While the impact of interest rates on stock prices is one complex factor among many, the effect on bonds is easier to figure out.  When interest rates rise, the prices of bonds and shares of funds that hold bonds will go down.  Why, after all, would you want to own old bonds with lower rates when you can buy new ones with higher rates?  Long terms investors that own bonds directly don’t have to worry about the price fluctuations on the open market very much.  If you plan to own the bonds and not trade them, then market conditions don’t really matter.  Your quarterly statements may show lower market values, but if the bond is held to maturity, you get the face value of the bond back.  You also received all of the interest payments you were due while you owned the bond.  The only thing you can really lose is the opportunity cost of being stuck in a low-interest rate bond when you could have potentially invested the money at a better rate.

Bond funds, on the other hand, usually represent a basket of different types of bonds with different maturities.  These are subject to price fluctuations driven by interest rates.  Recall that when you buy a bond, it will have a face (or par) value.  It will also have a coupon, which is an interest payment (most often paid twice yearly).  If you hold a bond to maturity, you will receive the face value of the bond.  If you do not want to hold the bond to maturity, you can sell it on the open market.  In these cases, the value is not the face value but what traders are willing to pay for it.  Since there are so many participants in these bond markets, the prices are fair and based on interest rates.

There is a negative correlation between bond prices and interest rates:  As interest rates rise, bond prices will fall.  When interest rates fall, bond prices will rise.  This makes sense.  When rates fall, old bonds pay a better interest rate and are thus more profitable than the newer ones.  Always remember that on Wall Street, you always pay up for future profits, and the fair price of any instrument is relative to all other instruments.  Bond investors are usually seeking very low risk, but they want to maximize their risk-reward ratio, as do all investors, regardless of asset class.

Holding individual bonds provides some benefits to investors, mostly in the form of control.  If you hold individual bonds, they can be sold whenever it suits your investment strategy, and you can maximize your tax benefits.  There are downsides as well.  You may have liquidity problems and have trouble selling your bonds if you ever need to liquidate them.  If you wish to reinvest your coupon payments, you must monitor your gains and repurchase bonds yourself.  This strategy is best for high net worth individuals that have an advanced tax strategy and a willingness to actively manage investments.  For the average person investing in a tax-sheltered retirement account, bond funds are likely the best bet.

Bond funds hold a wide variety of bonds with different maturity dates.  Because of this, bond funds pay coupon payments to investors on a monthly basis.  If you set up your account to automatically reinvest these funds, the fund managers can use the money to buy new bonds with the new higher interest rates.  In addition, as bonds mature with time, the face value of those mature bonds can be redeployed in the new interest rate environment.  With billions of dollars flowing into funds in this way, funds can overcome the interest rate losses in a relatively short period.  Most bond fund managers are not passive; they are constantly working to make sure that the fund holds face value as well as paying a handsome coupon payment.  These funds are very competitive, and performance matters to the fund managers.

If you know you can do better with another company’s fund, then you will move your investments.  Fund managers without investors quickly find themselves unemployed.  Rebalancing bond portfolios is quite different than rebalancing stock fund portfolios.  Bond fund managers can be very successful in keeping returns high because of the singular importance of interest rates in bond performance.  The FOMC will tweak rates from time to time to hit a target, but they telegraph these changes well in advance and make them slowly (for the most part).  This is a matter of mathematics more than the reading of tea leaves and crystal balls relied upon by stock pickers.

If we examine the return of bond funds over time, we find that interest rates are the most important determinant of performance and the face value of the fund’s shares is of little importance for long-term investors.  This is why good fund managers will constantly buy and sell bonds in order to improve these coupon payments to investors.  From a practical perspective, when interest rates rise, you can expect your coupon payments to rise with the rates (albeit with a brief lag).  Given this well-documented performance of the bond fund asset class, there is no reason to avoid such investments during periods of rising interest rates–unless you feel the need to liquidate.  In periods of rapid interest rate rise, it will take fund managers some time to get the fund up to the new par.

If you liquidate your holdings during that time, a mere paper loss becomes a real loss.  If you must rebalance out of a bond fund, (I recommend you balance your portfolio to your investment strategy at least yearly), you will want to wait until the face value of your shares is back in line with your entry point or higher.  This may sound like a losing proposition, but with reinvestment, you will own many more shares than you started with.  Stock investors often forget this important fact when dealing with bonds; with bonds, you make the bulk of your profits from coupon payments, not appreciation in the face value of shares.

If you own shares of Amazon, you do so because you expect the value of each share to appreciate.  If you own a bond, you expect the face value of the bond to remain relatively constant and to make a profit on coupon payments.  When you hear the talking heads on television lamenting the rise of interest rates and the destruction of bond prices, remember that these are traders, not long-term investors.  This is really a matter of the talking heads needing something to talk about since traders make money when there is volatility, and they like price movements (when they get the direction right anyway).

The bottom line is that 90% of the expected income form a diversified bond portfolio will be due to interest payments and not price changes in the face value of the underlying bonds.  Unless you plan to become a speculative bond trader, you will do just fine investing in bond funds that are well managed.  If you are a constant dollar investor, the benefits of rising rates are apparent.  Each dollar buys a bond with discounted price, and the interest payments are the same.

Constant dollar investing works best when there is at least some volatility, regardless of asset class.  Constant dollar investing coupled with reinvesting coupon payments is a powerful force that can more than compensate for temporary fluctuations in face values.  Over time, rising rates are good for bond investors.  There may be some short-term paper losses, but as managers rebalance portfolios to take advantage of new, higher rates, you will seem more profit from your investment.

Some funds focus on specific timeframes to bond maturity.  These are usually divided into short, medium, and long-term bonds.  The longer the term to maturity, the more susceptible to interest rate risk a fund is.  In other words, short duration funds will hold bonds with maturity dates in the near future, and those bonds can be cycled out much faster.  This means that the face value of the fund’s assets will recover from interest rate induced changes more quickly.  This resilience to interest rate risk is a tradeoff since the longer to maturity, the better the interest rate a bond pays.  Some advisors recommend selecting a bond fund according to the current interest rate trend, such as buying short-term funds during periods of rising rates and buying long-term funds during times of falling rates.  Another strategy is to buy a “total bond” style fund that buys all durations of bonds.  Another strategy is to invest across several bond funds with different risk profiles, which is the strategy that I will recommend in the final chapter of this book.

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