Rising Interest Rates

Published: Friday, January 7, 2005 at 1:57 p.m.
Last Modified: Friday, January 7, 2005 at 1:57 p.m.

The Federal Reserve Open Market Committee lead by Alan Greenspan recently increased interest rates. The Federal Funds rate has doubled this year to 2%, and Prime Rate is currently 5%, up from 4% at the beginning of the year. The next Fed meeting is December 11th. Are the rates going to continue to go up? If so, what does a rising interest rate environment mean to investors?

All the people who have adjustable rate mortgages will feel the pain of rising rates. When the Fed Funds rate increases, mortgage rates typically go up accordingly. Among other people who will see monthly payments go up are credit card holders who carry a balance. Card rates are directly linked to Prime Rate, as it goes up, so does the interest rate paid on the balance of the card. Investors who own US Treasuries have seen their values go down as rates have risen during the year, while CD owners have seen their renewal rates on the rise.

A common misconception among investors is that bond funds should be avoided whenever interest rates are on the rise. While it is true that bonds do not perform best when rates go up, stocks also tend to exhibit below-average performance. Historically speaking, the difference between stock and bond returns narrow when rates increase. Moreover, stocks continue to be more volatile than bonds. The best approach in all market environments is to remain disciplined and stick to your asset allocation plan. If you look back a decade ago, recall that in 1994 the Fed raised rates from 3% to 6% within a 12-month period. That same time period, the Lehman Brothers US Bond Index declined 2.9%. Many investors became nervous and shifted out of bonds by year-end. In 1995, the same bond index increased 17%. Most investors missed this abnormal rebound because they reduced or eliminated their bond exposure. So while it is impossible to predict future returns, implementing an appropriate diversified asset allocation plan and sticking to it is really the best approach. Interestingly enough, according to Modern Portfolio Theory, as an investor moves along the Efficient Frontier, the minimum risk portfolio is not one of 100% bonds. The lowest volatility portfolio has 25% exposure to equities, and 75% invested in bonds. Investments in stocks actually reduce a portfolio's standard deviation!

Another issue to keep in mind with regard to interest rates: according to the Fed, one of the key purposes of increasing rates is to reduce inflationary pressures caused by strong economic growth. Although economic growth can indicate weak performance by bonds, it is very good news for the stock market. Strong economic growth usually signals healthy corporate profits, which are the forces behind stock prices. Again, this is why it is so important for investors to include both stocks and bonds in their portfolios.

Looking at the bond market, Treasuries have typically under-performed other sectors during periods of rising interest rates. US Treasury bonds are among the safest, therefore offering the lowest yields, which in turn exhibit higher interest rate sensitivity as compared to mortgage-backed securities or lower grade corporate bonds.

The stock market may have sectors which perform better or worse as well. However, it is important to remember that trying to "time the markets", or guessing which industry might outperform sounds good in principle, but is virtually impossible in practice. In the long run, making investments based on short-term events such as political, social, or economic events is a losing proposition. To illustrate this statement look at the S&P 500 Index. A buy-and-hold investor in 1974 who invested $1,000 would have $31,647 by the end of 2003. Conversely, someone who tried to time the market and stayed invested 98% of the time, and only missed the 10 best months of the 30-year period, would only have $10,045, or one third of this money. (This is for illustrative purposes only. Past performance does not guarantee future results. The Standard and Poor Index is unmanaged and cannot be directly owned). Since you never know when that good month will come, are you willing to risk missing it? A better question is - why do you own bonds-for protection or for income? If the reason is protection, in addition to bonds, there are many innovative techniques to reduce the volatility of stocks. Also, there are some investments which actually increase directly due to rising interest rates.

Investors with long-term time horizons should not get caught up in worrying about short-term fluctuations or fads. Rather, focus on asset allocation plans and rebalancing to ensure proper risk and reward.

For more information, Rossi can be reached at Koss-Olinger Financial Group at 373-3337 or WJR@kofinancial.com. To read past articles, visit us at www.Koss-Olinger.com. Securities offered through Valmark Securities Inc., Member NASD/SIPC.

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