We are not market prognosticators nor do we believe that short term changes in the broader equity or fixed income markets should dictate your investment strategy. Your portfolio should be allocated based on your overall vision, needs and risk tolerance. We take a proactive approach rather than reacting to short term events working with you to develop a plan that is based on your vision. Our role is to help you define your goals and then implement and monitor a plan that makes sense for you. Part of this is being aware of broader legislative, economic and global events and recognizing potential risks for you while helping filter out the general noise from the media.
We believe that one risk many investors may face, without being aware of it, is interest rate risk. Over the last several years, investors have grown accustomed to historically low interest rates and have benefited from risking bond prices as a result. Ever since the Federal Reserve Board’s target fed funds rate–the rate at which banks lend to one another–hit a high above 19% in mid-1981, the long-term direction of rates has been downward. In the last decade, the Fed’s data1 shows the target rate has never been much higher than 6%. Since December 2008, the Fed has kept it at a previously unheard-of level between 0.25% and zero to try to ensure that credit would be available to promote economic recovery.
Because bond prices typically rise when interest rates fall, that decline in yields has produced a bull market in bonds over the last decade. But what happens when the trend reverses? Even if they continue to remain relatively stable for a while, ultra-low interest rates have nowhere to go but up. When the economic recovery begins to show signs of strength, at some point the Federal Reserve Board will typically begin to raise the target rate again. When that happens, bond prices will potentially begin to reverse their long-term direction and should start to drop; perhaps dramatically. Generally the longer the duration of the bond the larger the dip in price. Often thought of as ‘safe’ or ‘stable’ investments many investors have not experienced large drops in bond prices.
There have been four times since World War II where investments considered conservative and prudent “failed on a scale that has threatened the stability of the financial system” 2. The most recent being in 2008. “The crisis of 2008 was a fairly routine postwar event. Part of the routine was the hysteria of those who were caught in the trap – the media and the public. During the municipal bond crisis, the third world debt crisis and the savings and loan crisis , the general consensus was that things were never as bad as things are now and that we were facing the end of the postwar economic boom”2
In reviewing and monitoring your portfolio we look at a number of factors affecting the fixed income investments as well as the equities. If we feel adjustments should be made we will let you know. As with all things our goal is to be proactive in allocating your holdings, rather than reacting to what has happened.
When interest rates rise, longer-term bonds typically feel the impact the most. In an extended period of rising interest rates, bond buyers become reluctant to tie up their money for longer periods because they foresee higher yields in the future; the later the bond’s maturity date, the greater the potential risk that its yield will eventually be superseded by that of newer bonds. As demand drops and yields increase to attract purchasers, prices fall.
There are various ways to manage that impact. If you own individual bonds, you always have the option of holding them to maturity; in that case, you would suffer no loss of principal unless the borrower defaults.
We strongly recommend that you review your fixed income holdings with your financial advisor taking into consideration your risk tolerance, overall objectives and the potential impact of rising interest rates. You may consider shortening the duration, changing investments or reallocating your portfolio. If you are already working with us we will discuss this at your next review and contact you if any changes are recommended in the meantime. No action should be needed on your part but we are always happy to answer questions or address any concerns in the meantime. If you are not working with us we are happy to discuss you personal vision and review your portfolio in this context without any cost or obligation. Just give us a call (440) 974-0808.
1- Source: Federal Reserve Statistical Release Historical Data for Fed funds rate weekly since 1954.
2- The Next 100 Years, George Friedman
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Randy Carver and not necessarily those of Raymond James. Opinions are as of 4/26/15 and subject to change. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. There are special risks associated with investing with bonds such as interest rate risk, market risk, call risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences. To learn more about these risks and the suitability of these bonds for you, please contact our office. Investing involves risk and investors may incur a profit or a loss regardless of strategy selected. Past performance is not a guarantee of future results. Diversification and asset allocation do not ensure a profit or protect against a loss. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. You should discuss any tax or legal matters with the appropriate professional.
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