Monday, June 6, 2011

Rising Interest Rates & Its Effect on Fixed Income Investments

How long have we been listening to pundits on television tell us that interest rates are going up? One pundit on Fox Business actually said today, "you would be an idiot to buy bonds right now." This guy is the actual idiot in my opinion. He is broad brushing all of fixed income as being bad. As is true of most television pundits, he is flat out misguided.

Let's think about the possible rise in interest rates by the Federal Reserve for a moment. What is the main reason for them to raise interest rates? Historically, it has been to keep inflation in check. Well what has to happen for there to be inflation? Wages have to go up and the economy has to be expanding. My question to you is are we in the kind of economic environment where the economy is growing at a strong pace, personal incomes are rising and prices are also rising. Well, right now, only one out of three of these is happening, albeit modestly. This of course would be inflation.

In reality, we really have low inflation right now with some spikes like in energy and food. These two economic sectors are generally highly sensitive and volatile and usually spike up, then pull back. This is exactly what has happened. So, as of today, I would say that we had a short term spike in inflation, but it does not appear to be a strong upward trend.

Even assuming you believe the White House's take on the economy which I personally believe is way to optimistic, we still have horrible problems with housing and unemployment. The strength of this economy is not going to do much of anything without drastic action. The Democrats will lie and spin like they always do and the Republicans will pretend that they do not spend taxpayer dollars like drunken sailors. Both political parties are a train wreck in my opinion and the future is bleak for any meaningful change for at least until the next election.

A case in point is to look at both parties budget plans for the next 10 years. The President's plan expects to spend $27 trillion over the next 10 years. The Republicans expect to spend $26 trillion with Representative Paul Ryan's budget. In the grand scheme of things, that's not much of a difference over a ten year period.

So, when you think about interest rates rising, they typically rise faster in a strong economy. Are we there yet? Nope. High unemployment, a huge amount of housing inventory and little inflation are not the cornerstones of a scenario where interest rates are going to go up in a hurry. When they do go up, it is more likely to be a gradual increase and not necessarily a shock to the markets.

When a gradual raising of interest rates happen, it has the most effect on short term interest rates and less effect on long term rates. With a caveat, preferred stocks and high yield bonds typically pay the largest price when interest rates go up. Believe it or not, municipal bonds typically are not affected like high yield bonds are for example. The dividends tend to offset the increase in rates.

Do you really and I mean really think the Federal Reserve Bank is going to raise interest rates more than 1% any time soon? Forget about the idiot people that you see on television. Think for yourself.

Personally, I do not see interest rates going up a full 1% for probably at least one year or more. The only thing that would change my mind would be if Congress and the President eliminated the IRS, instituted a flat tax of less than 20% and lower the corporate income tax to 25%. The likelihood of all that happening in the next 12 months is slim to none. Therefore, I would not worry about interest rates going up more than 1% in the next 12 months.

Let's check back in 12 months and see if I was correct, shall we?