With the looming end to QE3 (quantitative easing round 3) the Fed’s massive $85 billion per month bond buying program designed to hold long-term interest rates artificially low, fixed income investors, and particularly those dependent on the income generated from their portfolio for living expenses, face a formidable challenge – how to invest in a rising interest rate environment without losing their shirt.
The theory behind the Fed’s bond buying program is that, if interest rates remain low, borrowing costs are also low, and therefore individuals and companies will borrow more, spend more, and thereby stimulate economic growth. The consumer spending side of this equation is particularly important, since consumer spending accounts for about 70% of total economic activity in the U.S. each year.
The problem has been that, thus far, despite historically low interest rates, consumers just haven’t been spending. Economic growth has been tepid at best, with the most recent reading for first quarter GDP growth at just 2.5% annualized. While this amount of growth, were it to be sustainable, isn’t terrible, it isn’t great either, and we have not seen the negative impact of the sequester spending cuts that began phasing in this past March. Once those cuts are fully implemented, experts estimate that as much as 2% could be shaved off of GDP growth. If accurate, this would take that 2.5% growth rate in Q1 down to just 0.5% annualized, or more or less a break-even rate of growth.
For bond investors, the challenge will come when the Fed decides when it will begin to tapper-off their bond buying, which will certainly result in rising interest rates. In fact, rates have already begun to rise somewhat, in anticipation of the Fed slowing the pace of their bond buying. The Fed meets tomorrow and Wednesday (June 18th and 19th) to review their policies, and will likely make some decisions regarding when to start tapering their bond buying activities. The 10-year treasury has already risen from a low yield of 1.66% to the current 2.19%, or by 0.53%. While this isn’t a huge move in absolute terms, it is a massive percentage increase of 32%. Clearly even with the Fed’s relentless buying, bond prices are falling because investors are selling in anticipation of Fed tapering.
Rising rates pose a serious threat to portfolio values. Those holding long-term bonds are especially vulnerable in a rising rate environment. While it is true that the investor can always hold bonds until maturity, no one likes to be in a situation where their portfolio value has fallen dramatically. Falling bond prices put the investor in a situation where, should they need to sell for any reason, they will likely be forced to take losses.
To avoid this very real possibility, bond investors should consider shortening maturities, meaning sell bonds with longer maturities and replacing them with bonds that have shorter maturities of 5 years or less. Staggering or laddering the portfolio with maturities from 1 year to 5 years is a simple way to spread the risk of the portfolio among the various maturities, while also placing money so that each year some bonds will mature, allowing for reinvestment at (hopefully) higher interest rates, once rates have moved up significantly.
While current income will certainly be lower if the investor shortens maturity, this should be a somewhat temporary situation. After a one to three-year time-frame, rates should have increased enough so that maturities can begin to be lengthened, resulting in an increase in overall income from the portfolio. The short-term loss of some income should pay-off handsomely through the avoidance of losses in the value of the long-term bonds held previously.
While it is not clear when exactly the Fed will begin to tapper their bond buying activities, we know they will do it eventually and in the near-term. It is inevitable that rates will rise significantly as a result, and that long-term bond prices will fall. Bond investors will benefit from being proactive and making appropriate changes to maturities before rates have risen.