Be cautious of current yield and rising Fed rate

Joseph G. Mowrer III, The Daily Record Newswire

Investors have been living in a world of exceptionally low yields for a long time now. The Fed has been keeping short-term rates near zero and continues to suppress yields on longer dated securities in its efforts to stimulate the economy.

Investors seeking current income are becoming impatient with the abysmal rates they can earn on fixed-income investments. Indeed, the average money market rates are .12 percent and average 2-year CD rates are .4 percent (source bankrate.com).

Typically, when market rates are low for an extended period of time, fixed income investors begin to reach for yield by increasing their risk. This can be done in two ways. Investors can either take on additional credit/default risk, or buy longer maturity securities. Both can add significant risk to a portfolio, and investors should proceed with caution.

Increasing credit risk should only be considered for a small allocation of a portfolio, as the added yield comes with increased chance of default. Interest rate risk is perhaps less understood by average investors, but poses huge risks to a bond investment.

Consider the 10-year Treasury bond, which has a current yield of 1.9 percent, and duration of 9 years. Duration is a measure of a bond’s sensitivity to interest rate movements. For this bond, a 1 percent move up in interest rates could create 9 percent erosion to the price of this bond. Said differently, it would take only a .25 percent increase in interest rates to lose the equivalent of one full year of interest. And with rates stuck on the floor, it seems most likely that the next move in interest rates can only be in one direction — up.

When the fed determines it is time to increase interest rates, it can happen very rapidly and cause pain to fixed income investors who are over exposed to longer maturity bonds. In
1994, the Fed increased the Fed Funds rate from 3 percent to 6 percent in just over a year. And beginning in 2004, rates were ratcheted up from 1 percent to 5.25 percent in just over 2 years. It is possible, and perhaps likely, when rates do eventually begin to rise, it could be swift.

There is no reason to suspect a sharp rise in interest rates anytime soon. The Fed has indicated that it will be very reluctant to disrupt the recovery, and will likely keep interest rate low until the jobs recovery is on firm ground.

For this reason, investors should not immediately purge their portfolios of all longer dated holdings and run for the exits. It is wise, however, to monitor the maturity dates on your bond portfolio and trim duration to within your risk tolerance. If you own bond funds, and have for a while, it is likely the risk characteristics of these funds have changed relative to today’s interest rate environment and it might be time to revisit your holdings paying careful attention to duration.

By sacrificing some current yield now and reducing duration of a bond portfolio, an investor’s fixed income portfolio will be better positioned to weather an imminent rising rate environment.

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Joseph G. Mowrer III is a senior tax-sensitive fixed income analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.