“We Have Liftoff”?

“We Have Liftoff?”

What happens when the Fed starts to raise rates?

Photo: Kim Shiflett. Source: NASA

Many investors are worried about the value of their bond portfolios. When interest rates rise, bond prices fall. It’s simple mathematics: bonds have a contractual future payment stream, and that payment stream isn’t worth as much when the discount rate rises. With the Fed now poised to raise rates, their portfolios may be at risk. As a result, many investors have shifted to short-term bonds, because short-term bonds are less sensitive to interest rates than long-term bonds.

But just because some interest rates rise doesn’t mean they’ll all go up. It depends on the type of bond, the credit quality, and when the bond matures. All bonds carry a certain degree of credit risk; there’s always a chance that the issuer won’t be able to pay its obligations on time. As the economy improves, the risk of default goes down. And long term bonds are different than short term bonds. Inflation risk is a much bigger issue. When the Fed lifts rates, the risk of inflation may actually go down. So even if rates rise in one part of the yield curve, they may not go up elsewhere.

We saw this play the last time the Fed raised rates. Between the end of 2003 and 2006 the Fed increased interbank rates from 1% to 5.25% over the course of two years. The economy was recovering from the dot-com crash, and the Fed moved from an easy policy to a fairly restrictive stance. This was a pretty aggressive set of moves on the Fed’s part.

Fed Funds Rate from 12/31/02 to 12/31/07. Source: Bloomberg

But interest rates didn’t move up uniformly across the curve. The Fed had been pretty clear about its intentions. Then, as now, they were anxious to return monetary policy to a more normal stance. There had been lots of speeches and comments by FOMC members. So the market had largely anticipated rising rates.

Consequently, as the Fed began to increase rates, long-term rates didn’t go up very much. In fact, long-term corporate bond yields actually fell a little bit. It’s hard not to look back at those rates with a little bit of nostalgia: investors could actually receive over 6.5% for a 15-year corporate bond!

BBB Corporate Bonds from 5/31/04 to 7/31/06. Source: Bloomberg

Similar to back then, the Fed has been especially clear about their intentions lately: they want to return monetary policy to a more normal stance, with short-term interest rates close to the rate of inflation. So the bond market has largely anticipated their expected policy actions. Currently, Fed Fund futures imply a 76% probability that the Fed will lift rates at their next meeting.

If they do, it’s quite possible that longer rates will remain stable or even fall. The yield curve could flatten. Sometimes, what seems riskier is actually safer.

Douglas R. Tengdin, CFA

Chief Investment Officer

By | 2017-07-17T12:22:19+00:00 December 7th, 2015|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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