Higher Interest Rates: Foregone Conclusion? Cause for Alarm?

July 19th, 2013

by Don Gould

Note: This post is an excerpt from Gould Asset Management’s Economic and Market Review for the Second Quarter of 2013, the entirety of which can be found here.  We’ve reprinted it here for the benefit of our blog subscribers.

The run-up in interest rates over the past several weeks has brought a chorus of declarations that the secular decline in rates (and the corresponding bond bull market) which began 32 years ago (just after Ronald Reagan took office!) is officially over. As day follows night, what went down must now go up. And so on. This is at least the 8th time over the three decades that very smart people have announced the end of the run.

Perhaps this time they are right. A look at the accompanying chart confirms that, at a minimum, the next decade will look different than the last three. With a lower limit of zero, interest rates don’t have much room to fall further. However, the same has been said of Japanese interest rates for the past 15 years. Confounding the pundits, rather than commencing a long-term rise, Japanese rates have instead simply languished below 2% for years on end. Countless fortunes have been lost betting on the “inevitable” rise in Japanese bond rates. Of course, there are many important differences between the US and Japan, but the Japanese experience is worth remembering as we think about possible outcomes at home.

Assuming rates do turn upward, there is still the question of whether investors should view higher interest rates as bad news, a position set forth daily by a nearly hysterical financial media over the past several months. Completely lost in the discussion is the question of why rates are rising. If they are climbing as a result of heightened inflation expectations, arguably it is bad news. But this does not describe recent rate hikes. Instead, we’ve seen higher real (net of inflation) returns on fixed income securities. (See chart.)

So back to our question, good news or bad? For the retiree rolling over short-term bank CDs, higher interest rates are unquestionably good news. But what about the typical long-term investor who has a meaningful allocation to bonds?  On that score, we think higher rates are good news, too.

Yes, higher interest rates cause the market price of existing bonds to fall. This shows up in a lower account value on the month-end statement. But rising yields also mean that bond interest and bond principal get reinvested at higher rates in the future. For investors with time horizons substantially longer than the average maturity of their bond holdings (which describes the vast majority of our clients), higher rates actually imply greater total cash flow over their investment horizon.

 

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