Interest rates are finally rising: are you ready? Flashback to 1981. The yield on 10-year U.S. Treasury bonds topped out at 15.8 percent, consumer prices were doubling every five years, and 30-year mortgage rates hit 18.5 percent. Good times.
Since those difficult days, the steady decline in interest rates has been relentless. The reasons are many, but the staggering reduction in the cost of capital conspired with the coming of age of the baby boomers to fuel the greatest economic expansion in history. Then came the financial crisis of 2006, which proved especially resistant to traditional monetary policy initiatives, thanks in part to the historically low level of interest rates.
Once the Fed had cut its reference rate to zero, the bank called an audible and went on a bond buying spree to the tune of $3.5 trillion. Other central banks around the developed world initiated similar measures, flooding the globe with liquidity (read: cash). The result of expansionary monetary policy combined with unprecedented global wealth put even more downward pressure on rates.
By 2016, the benchmark 10-year Treasury yield hit an all-time low of 1.37 percent, while British bond yields plumbed depths not seen since the founding of the Bank of England in 1703. Germany, Japan and several other major nations actually experienced the phenomenon of negative interest rates, a condition that implies a loss of capital for savers in safe government bonds.
At long last, the cycle has flipped. The 10-year Treasury yield today stands at 2.64 percent, with the Fed poised to raise interest rates three or four times in 2018.
So what happens when a 37-year trend changes direction, especially given that most investors have at best a hazy memory of the obverse? It is useful to recall that in general, prices of fixed income assets like bonds move in opposition to the level of interest rates. When rates rise, bond prices fall, as newly minted paper offers more attractive returns than older notes issued with lower coupon rates.
This has significant implications for bondholders, especially for investors in mutual funds and ETFs that hold bonds. Bond funds delivered robust returns during the long declining rate cycle.
Now the proverbial shoe is on the other foot; as rates increase, bond values inside those funds will fall, and depending on the characteristics of the fund may decline more than the cash income, resulting in permanent capital losses. And while those capital losses are likely to be relatively small, most bond fund investors are unaccustomed to seeing red ink on their statements.
As rates continue to ascend, other classes of income-oriented investments are also likely to be pinched. Preferred stocks, for example, are essentially long-maturity bond proxies with lower priorities in time of distress, and are therefore likely to suffer declines.
Higher-yielding equity securities like REITs and MLPs are likewise subject to some price pressure as safer alternatives like bonds and CDs begin to offer enhanced returns. Many of those alternative structures have some ability to adjust to rising rates over the long term but usually feel some pain as rates rise in the short term.
This is not an argument against bonds. A rational asset allocation for most investors includes some percentage of "safe" assets to serve as insurance against inevitable and unpredictable market corrections.
But avoid the temptation to extend maturities to enhance cash flow. Longer-dated bonds take a bigger hit as rates increase, so review your funds and evaluate the average maturity to help manage the potential downside as interest rates continue their inexorable rise.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.