Commentary 7/3/2013

The biggest story in financial markets over the last month has been the sudden rise in interest rates resulting from the Fed’s warning that it may pull back their monetary stimulus. This is a big story because as interest rates go up, bond values go down. This happens because when rates go up, new bonds come to market paying higher interest rates. Investors have a choice of buying the new bonds with higher rates or the old bonds with lower rates. They, of course, choose the bonds with the higher rates, lowering the demand and, therefore, the price for the old bonds.

There are two big things to think about with rising rates: where are rates going and what does this mean for my bond portfolio? Rising interest rates mean different things for different types of bond portfolios. Bond mutual funds will have a different experience than individual bond portfolios. Individual bond portfolios are better positioned for a rising rate environment because regardless of where rates go, the set coupon payments continue to be paid and the principal is returned at the bond’s maturity. The individual bond’s value may go down for a time, but the same cash flow still comes into your account and the bond will still be worth 100 cents on the dollar at maturity. These cash flows, including coupon payments and principal, can also be reinvested at the prevailing higher interest rates as they are paid.

On the other hand, bond mutual funds, ETFs, and closed end funds are sensitive to the fall in the prices of the bonds within the fund. If investors in the bond mutual funds decide to sell when the bond values are down, losses are locked in for the investors who sell, as well as for those who remain in the mutual fund. This is why even the largest bond funds have underperformed bond indexes. Bond mutual funds are forced to sell bonds at market prices when investors pull out regardless of where bonds prices are. This is what happened in May and June as interest rates shot up and bond market prices fell.

One thing that can hurt investors in both individual bond and bond mutual funds is inflation. When inflation rears its ugly head, the interest payments from both types of bond investments lose purchasing power. We cannot purchase the same amount of the goods we need with the same amount of money.

However, what we seem to be experiencing now is very low inflation or even declining inflation; and there are many different inflation measurements we can look at to confirm this. We prefer to look at what the markets tell us rather than the government statisticians. The market for commodities is a great place to look for inflation expectations. If businesses are worried their raw materials will be more expensive in the future, they will buy them now. If they think their raw materials will be cheaper, they will wait. The markets are showing a lot of waiting. Gold, despite having limited commercial use, is a good commodity to look at because it is considered the classic inflation hedge – as inflation rises, typically so does the price of gold. The price of gold has plunged 40% this year and, with it, the reputation of some famous hedge fund managers.

The other big question -- where are rates going? -- is tougher to answer. Short-term rates may actually decline for a while. Markets sometimes have knee-jerk reactions and sell off more than they should. We believe this is what happened after Fed Chairman Ben Bernanke’s comments a couple of weeks ago. In fact, we are still in the midst of it as the rebounds in bond prices are normally slower than the fall. Over time, rates will certainly increase. We hope they do. As they do, we will reinvest the interest and principal payments we receive in securities with higher interest rates. There are also many types of bonds and strategies that can do well in rising interest rate environments. However, that is a subject for another blog.