A Distinct Lack of Interest

June 18, 2013

"The era of low interest rates is over ." 

That  statement was certainly applicable back in May, when investors worried that the Federal Reserve was nearing the end of the historic monetary shenanigans it had implemented to jump-start the economy back to life and avoid a depression.

Yields on the U.S. Government 10-year bond "soared" more than 30%, rising from a 1.63% low in early May to 2.23% before easing back down slightly. 

Of course, that was nothing like the rise in rates at the bottom of the 2009 stock market, when bonds went from lows of 2.13% to 3.89% in just a few months. Or the climb from the unbelievably low level of 2.38% in October 2010 to 3.65% by January 2011.

Predictions about rates having nowhere to go but up might have looked equally correct half a dozen times in recent years – yet been wrong.

The bottom line is that interest rates are near rock-bottom. Sharp rate changes are being triggered by investors' alternating fears of global recession – which can drive rates down – and Fed exit fears, which could drive rates up  as the Federal Reserve stops trying to maintain low interest rates. 

I don’t know what will eventually send 10-year rates on government bonds back to "normal" levels of maybe 5% or higher. It’s easy to look at a multi-decade chart of interest rates and expect rates to go back up and stay up any day now. 

Strangely, few experts look at long-term charts of U.S. economic growth and expect us to go back to high growth rates any time soon. Only the bad things from the past, like inflation, are expected to return. 

Sharply higher interest rates will hurt all asset prices, some more than others. We saw that in May when higher income investments, including "safer" bond alternatives like real estate stocks, utilities, lower volatility stocks, and emerging market bonds got slammed just shy of double digits.

We don’t get to see daily home prices, but it’s a safe bet that a big sustained move up in interest rates would send home prices back down, since homes outside of a real estate bubble should trade somewhat like longer-term, medium-credit grade bonds.

What we do know is that popular investment theorems don't usually pan out. Does this mean rates can’t go up and stay up? No, but there are many more scenarios that could happen just as easily – more unexpected scenarios, ones that today’s income investor may not be positioned well for.

Hundreds of billions have gone into bond funds in recent years, so we don’t expect any bond funds to perform particularly well over the next 5 – 10 years. That doesn’t mean bonds don’t belong in your portfolio, however. Even higher-risk investors can benefit from holding bonds, if only to have something that could go up in a stock slide and be easily shifted to stocks following a market shock.

Moreover, much of the bond money is in shorter-term bonds. Bond buyers are so focused on interest rate risk avoidance that the entire bond market index is rather low-duration and therefore not very sensitive to interest rate fluctuations. Wall Street sells what people want – and they want low interest rate sensitivity. This is how adjustable rate mortgage debt became so popular with investors.

Here are some interest rate scenarios to consider:

1) Forget the Fed and inflation. Let's say rates return to normal. We'll see money around the world clamoring for yield. More money means a lower return over inflation than we've experienced in the past. The days of earning 3% more than inflation in safe bonds might be gone. Maybe safe bonds will only yield inflation. And safe bonds with no interest rate risk (shorter-term bonds and money markets) might yield less than inflation for most of the future, except during relatively brief periods of short-term rate increases by the Fed.

2) Interest rates could go up due to increased borrowing and a stronger economy. Investors that favor longer-term, high-grade bonds over stocks or real estate will be unimpressed by this future, but those with more economic and inflation-focused assets will do fine.

3) Rates might not change for years. Not that they will go down to sub-1% on a ten-year bond (like Japan,) but why not just kick around 2 - 3% for the next decade? This permanently low rate scenario is no less likely than rates returning to the higher levels of decades past. Low rates and big government debts mean inflation is around the corner? Tell that to Japan, with its lower rates and bigger deficits.

4) What if shorter-term rates go up, and longer-term rates barely budge? There are hundreds of billions, probably trillions, of dollars that would love to load up on longer-term bonds if rates climb significantly. Such pent-up demand might limit rate increases on the long end of the curve. Moreover, we could see an inverse yield curve, even with high inflation, if investors think it will end and try to lock up longer rates in anticipation of the next downturn in the economy and rates.

5) The best place to be when rates rise is...the bond market? The total bond market has just over a five-year duration. That means if rates go up three percentage points - from the low roughly 1.8% yield of the bond index to 4.8%, you might lose 15% in the price of the bond fund. And that’s not factoring in the yield you'd earn along the way. This big drop is not much more than the amount safer bond alternatives fell in May alone.

6) Yield reach could flop harder than the bond market index. Since junk bond and emerging market bonds already yield bare minimums over safe government debt, they should be as interest rate sensitive to rising rates. There is no cushion. Moreover, if defaults rise along with rates, (an unexpected turn of events, given that rising rates should occur in a stronger economy) the rate spread over safe bonds could increase, amplifying losses in an asset class that's supposed to fare better in a rising rate environment.  

7) Could long duration bonds do better? If rates spike quickly, longer-term bonds could lose high double digits, but in a flat rate environment, longer-term bonds pay extra bonus money over shorter-term bonds. All these years of modest returns when rates were going to rise "any day now" add up. How many years of earnings 3% over short-term bonds before losing even 20% doesn’t matter all that much? 

If we go to long-term government bond rates of 5.7% (like back in 2000) from current low 3.2% rates, long-duration bonds could lose 30%. But why can’t it take as long for rates to rise as it took for them to fall down? That would mean earning 40% in interest along the way (average yield 4%, not even including compounding). What’s the expected 10-year return on cash? Is this roughly 10% return  – albeit unfavorable, since it's loaded with higher tax income and deferring a tax loss until sale – much worse than the likely return in money markets/cash over the next 10 years? 

For much of the last five-plus years, there have been lots of popular strategies to protect us from rising rates, rising inflation, a falling dollar, and lackluster U.S. growth compared to the rest of the world. Essentially, all of them have failed. Look at the five-year returns on commodity funds today, or precious metals funds. Check out emerging market funds compared to the S&P 500, and you'll find average annual returns over 5% for the S&P 500 index fund compared to  negative 2% for emerging markets.

The only thing to fear is popular investment strategies for the fearful.