Rocking Roller Coaster – Way Cool!

Recently, my family and I went on vacation to Disney World. My girls talked me into riding the Rock ‘n’ Roller Coaster. This ride is a roller coaster that plays unbelievably loud music and is completely dark. You are effectively blind, never being able to anticipate when you will lose your stomach next. Of course this coaster has many cars, but only two mattered to my three girls who are just 12, 10, and 10 – the front and the back.
Our twins, Sophie and Phoebe, sat at the front and had unobstructed views of darkness as the coaster went from 0-60 mph in 3 seconds. As the cars began to cascade down the first drop, the first car was pushed faster down the hill, giving my twins a huge thrill. They described it to me as “way cool.”
My 12 year old, Maeve, and I were in the back of the coaster where it was a different story. All I could see was hands in the air in front of us and, all I could hear was shrieking and, of course, we would never arrive first. But we did have a unique experience – whiplash.
Maeve and I got the rush of being thrown from side to side as the roller coaster rounded corners at top speed. After the first few cars had been pushed around a corner, we, in the last car, were ripped around the corner as we were pulled along. At 12-years old, what a rush! At 45, I’m not so keen on the last seat on a rollercoaster. Yet that’s where I find myself, my clients, along with everyone else who deals with the unfortunate effects of those crazy twist and turns of interest rates.
To begin, let me give a rudimentary explanation of how bonds work. A bond, of course, has its actual value, the purchase price you pay for it. It also has a steady stream of income because a bond pays interest, known as the yield. Each bond also has a maturity date. The maturity of a bond is the duration of time that the issuer agrees to pay interest on it. So, lets say you purchase a corporate bond for $10,000 with a 10-year maturity for par ($100) and it is paying 3% interest, or $300 for 10 years. What happens if interest rates rise to 6% and I want to sell my bond in 5 years? Who would pay me $10,000 for a bond that yields 3% when they can now pay $10,000 for a bond that yields 6%? No Cutter Family Finance reader would do that. So, if I were to sell my bond, I would need to sell it at a discount, probably at a $5,000 resulting in a 50% loss on my purchase. Not a good scenario.
We have spoken over the past several months about the actions of the Federal Reserve, so I will not go through them again here today. Although, I will remind you that by engaging in a deliberate plan to flood the markets with money by buying bonds and then announcing that it will pull out of the market, the Fed created a mighty storm in fixed income. The Fed’s announcement caused interest rates to shoot to the moon (thereby decreasing the value of many bonds) before falling back a bit. As you have read in my recent articles, we thought that this might happen so as a precautionary measure our top low risk fund managers moved our client’s assets out of bonds and into cash in late May and early June. (You know I continually harp on the idea that a buy and hold investment strategy will not work in our current market conditions, this is one example of that philosophy’s shortcomings.)
Here is my question to Cutter Family Finance readers, “Where do rates go from here?” To answer this we must look at two different factors at the same time. The first is the economic health of the country. The second factor is the possible unwinding of the yield compression (difference in interest rates between bonds of the same maturity, but different quality). Both factors are extremely important.
Economic health should indicate to the Fed if and when they will back off of its aggressive bond buying. It appears that, as we expected and have discussed, the Fed’s initial comments about tapering were premature since it has spent a lot of energy telling us that we were missing their point. Really? (1) Cutter Family Finance readers know that the Federal Reserve will back off of bonds, eventually. It won’t be today. It won’t be until the economy shows significant strength, which I personally do not see happening anytime soon. As a result, it is more likely that Treasury bonds and extremely high quality bonds will actually see their interest rates fall in the months ahead.
This is particularly true of short-term interest rates. When investors around the world get skittish they turn to U.S. Treasuries for safety. But not all maturities (duration) are created equal. If an investor’s goal is to preserve purchasing power, they do not like maturity risk since the longer the maturity, the longer the risk of rising interest rates, which results in the possible loss of principal. They stay close, which means a possible increase in demand for short-term Treasuries if there is another global economic scare, such as another crisis in Europe or China. This could cause a drop in yields and a bump in the purchasing price of a bond.
The outlook is very different for high yield bonds and emerging market bonds. These bonds are perceived to be more risky than Treasuries. While the past several years have been good for these sorts of investments, it looks like the bloom is off the rose, which is why if you are buying and holding these bonds you may have seen your principal eroding over the past month or so.
Folks who were advised to simply buy and hold such bonds because they offered more interest now realize the increase in interest comes with an increase in risk. If the U.S. economy and/or the world economy experience a further decline, folks who continue to hold these high yield and emerging market bonds can expect these to fall in price as demand drops off, causing their interest rates to rise.
So, it appears that the days of exceptionally cheap mortgage money and auto loan money are over. The rates are still low today, but the chances of seeing sub-4% on a mortgage again remain slim. Bankers recently had the “Fear of Ben” (Bernanke) put into them, and it will be hard to shake it.
If you’re in the market for bonds, do your due diligence. While there’s risk, we see significant opportunity.
For those willing to do their homework, there are many bonds that have been battered at the back of the rollercoaster and now offer a decent yield, just don’t be talked into buying junk and do not prescribe to a bond buy and hold strategy because, You Deserve More!