30 Apr A Rising Tale
A Rising Tale
“You Need to Focus”
Interest rates. We are constantly bombarded with these rascals. To some, understanding them is easy. To others, forget about it. This is A Rising Tale, because that is the talk of the town these days as the 10-year treasury has risen above the magic 3% mark. Why it’s a magic number nobody really knows but everywhere I look there’s an article about rising rates. So, I thought I would write a tale to help people understand what it might mean to them and to understand what falling rates have meant to them.
What happens when interest rates rise? Said differently, what happens to you when interest rates rise, because after all, that’s what you care about. Ultimately, interest rates are out of our control but how we position our lives around these subtle movements greatly influences our financial destiny.
Let’s start with a simple 3 question quiz about interest rates and see how you do. I have either formally or informally given hundreds of people this same quiz and it never fails to surprise me just how convoluted people think about such a simple concept. Here’s a clue–Who is buried in Grant’s Tomb?
- If you were to invest $1000 in a 10-year US government bond that is currently paying 3% annually and if you held it to maturity what would be your annual rate of return over the 10 years?
- More than 3%
- Less than 3%
- If you were to invest $1000 in a 10-year US government bond that is currently paying 3% annually and if you held it to maturity what would be your annual rate of return over the 10 years if interest rates were to consistently rise over the next 10 years?
- More than 3%
- Less than 3%
- If you were to invest $1000 in a 10-year US government bond that is currently paying 3% annually and if you held it to maturity what would be your annual rate of return over the 10 years if interest rates were to consistently fall over the 10 years?
- More than 3%
- Less than 3%
Let’s tally up our answers. If you answered C or 3% to all of the above—you are a winner. Anything other than C to all three questions means you have no idea how bonds work and it’s time to focus.
To digress a bit and why the subtitle of this tale is “You Need to Focus” let me tell you a story. When I was a little boy I loved sports and was constantly on some sort of court or field. My father would periodically show up to games and with his Cuban accent offer words of encouragement. His favorite line was Carlos, “You need to focus.” You can imagine how the word focus sounds when said with a Cuban accent. Everyone would cringe a little and ultimately laugh. It was a source of amusement. After a while he caught on but to my surprise, he kept doing it. I asked him why he persisted and he said—”now that everyone knows, it’s my way of telling everyone to focus, otherwise we are ……” So, if you are reading this–you need to focus, otherwise…
So, the first takeaway from this tale is–a bond held to maturity pays the stated interest rate no matter what happens in between. Now comes the second takeaway.
What happens to the value or price of this 10-year bond along the way? We bought it for $1000 and if rates go up and I want to sell it, what can I sell it for? After all, this is A Rising Tale. The answer is also simple and here’s a good way to think about bonds or for that matter anything you own. On any given day from the date you purchase a bond until the day it matures, whether you know it or not, you are making a decision. You are deciding to hold on to your bond or to sell it. We already learned what happens if you hold on to it. But what happens if you go to sell it? I like to answer this question by turning it around and asking how much would I pay for something someone else owns?
So, let’s set up a hypothetical with the same 10-year bond that was purchased at a 3% interest rate but only now it is a year later which means the 10-year bond that was purchased for $1000 only has 9 years left until maturity. Let’s say interest rates have gone up since then and I could instead purchase a 9- year bond that pays 4% interest. Which is a better investment or are they equal? Please think before you answer.
If you answered that they are equal, you are correct. They are equal. Any other answer and it’s time to focus. The 10-year bond has morphed into a 9-year bond and with current interest rates on a 9-year bond at 4%, the 4% return is what any buyer, anywhere, expects to receive. This leads to the second takeaway which is —the interest rate today is the interest rate that everyone expects to receive when they invest their money today. The past does not matter.
Here comes take away number 3 and where things get a bit complicated. How much is the 10-year bond that was originally purchased for $1000 a year ago and pays 3% annually worth today? Remember it has morphed into a 9-year bond that pays 4%. The math is complicated but the intuition to understand it is simple. On one hand I have a bond that pays me 3% per year or $30 per year for the next 9 years and in 9 years is worth $1000. On the other hand, I have a bond that pays me 4% or $40 per year for the next 9 years. This means I will receive $90 less with the 10-year bond than the 9-year bond. This means there is no chance I pay $1000 for the 10-year bond. What would I pay? The approximate answer is $910 which makes up for the $90 difference. If you go to a bond calculator and solve for the actual answer you see it’s not $910, it’s $925.65. The reason why it’s higher than the $910 is not important and well beyond your need to focus unless you plan on becoming a bond trader. This means precision isn’t required to understand our third takeaway which is–when rates rise bonds lose money and when they fall bonds make money.
The fourth takeaway from this tale is an understanding of the difference between rising interest rates and falling interest rates. This is critical because right now as you read this tale there is someone looking at the rate of return of a top-rated bond fund that expects the future will approximate the past. Don’t fall into this trap and absolutely do not let some know-nothing advisor try to convince you otherwise. We’ve lived through the golden age of bonds over the last 35 years and by their very nature, a day of significant underperformance relative to their past is on the horizon.
Let’s look at 2 scenarios. In the first you invest $1000 in a 10-year bond that pays 3% and a year later 9-year bonds are paying 4%. In the second scenario, the exact opposite happens, you invest $1000 in a 10-year bond that pays 4% and a year later 9-year bonds are paying 3%. How much is each bond worth a year after purchase and what has been your rate of return? The tables below say it all for various interest rate combinations. The bond you purchased in a rising rate environment is worth $925.65 and you collected $30 of interest on it for the year for a negative rate of return or loss for the year of 4.44%. The falling bond is worth $1077.86 and you collected $40 of interest on it for the year for a rate of return of 11.79%.
Interest Rate at purchase
Interest rate 1 year later
Value of bond 1 year later
|Interest collected during the year|| |
Value plus interest collected
The 1-year rate of return
So, now can a 10-year bond that pays 4% make me 11.79% in as year? The answer is rates fall to 3%. Conversely, how can a 10-year bond that pays 3% lose me 4.44% in a year? The answer is rates rise to 4%. The table above shows various combinations of falling and rising interest rates. But what you need to understand is that if rates rise to 4% in a year, then 1% per year thereafter, and you keep buying 10-year bonds—-you will lose a lot of money. You can also see how the last 35 years as rates fell from the mid-teens to under 2% represented the Golden Age of bonds. The key word is represented and not represents. If you are basing and bond decisions on the past—-stop. While it may seem plausible to think that 35 years of data is sufficient to make good projections—which it is in many cases—-it is not the case when it comes to bonds. Takeaway number 4 is-the past is not a good indicator of the future.
Great. I learned the following but what do I do with it?
1) A bond held to maturity pays the stated interest rate no matter what happens in between.
2) The interest rate today is the interest rate that everyone expects to receive when they invest their money today. The past does not matter.
3) When rates rise bonds lose money and when they fall bonds make money.
4) The past is not a good indicator of the future.
Here’s the first thing to do. If you think that rates are actually going to rise, then you don’t want to own bonds. If you think they are going to stay constant and you are satisfied with the returns they currently provide which is 3% or less for treasury securities under 10 years maturity-then you can hold them. If you think rates are going back down and you own bonds you will be happy if you are right.
But that is just an analysis of bonds in a vacuum. Here’s the real problem as I see it. Most people have some type of balanced portfolio which includes some combination of stocks, bonds and cash equivalent securities. A typical combination might be 50% stocks, 40% bonds and 10% cash equivalent. The problem with this combination is that with cash yielding close to 0% and government bonds at 3% at best, the typical balanced portfolio can’t expect to make the types of returns they made in the past. They can’t even come close is the real problem. This means that if you stick to traditional investments and you manage them passively you are probably going to go backwards over the next 5-10 years relative to inflation. This is not a pleasant thought especially for those that live off of what their investments produce. Is there an answer?
There is no right answer. If you are happy with mediocrity or have enough money where your rate of return does not matter then consider yourself lucky. But for those that want more or need more, you have to explore other options. These include systematic trading approaches, higher yielding, higher risk bonds, alternative investments or perhaps you’ve got a great idea. In any event, don’t expect the good times to continue forever. Always remember, if something is too good to be true—it isn’t and the returns we’ve seen on bonds over the last 35 years is not what to expect over the next 35 years.
In closing, let me encourage you to explore an alternative investment that has recently come to my attention. It is a CD or Certificate of Deposit. Like other CDs it is FDIC insured. The twist is that instead of paying a fixed interest rate it pays a variable interest rate based on the performance of a low volatility index. What’s intriguing is that the issuing bank guarantees that if the index does not perform, you get 100% of your money back. Granted, you may make a 0% rate of return if the index does not perform but you may make considerably more than a traditional plain vanilla CD. That’s the bet.
In our opinion it is a legitimate substitute or compliment to a traditional bond portfolio and is something we would have never said before. We’ve analyzed hundreds of fixed income instruments in the past and these types of hybrid CDs have always come up lacking in one way or another. The main reason is that while they guarantee return of principal they don’t provide enough inducement on the upside. These new breed CDs, pegged to a low volatility index have caught our attention and we are adding them to our solution roster of securities our clients can expect to one day see in their portfolios. If you would like to see our back-tested results or for a list of banks issuing these types of CDs, contact us. We see these CDs as a potential solution to the rising interest rate scenario and we very much like the way the underlying indices are constructed.
As always, our advice is never meant to be current but instructive. Our tales are evergreen. This means that if we add a particular security to our roster of solutions it means we like it for the long haul.