Interest Rates: The Good, The Bad, The Unknown
About the author: Jeff Martin is a financial advisor at Cornerstone based in Reno, NV. Jeff has earned the Life and Health Insurance Licensure and has passed the Series 65 examination. He enjoys being able to help clients create customized strategies for their portfolios based on their unique financial goals.
Interest Rates: the good, the bad, the unknown
We are currently in a bit of a precarious environment when it comes to interest rates and the rippling effect they have in our lives. To set the stage, interest rates have been coming down for nearly four decades. This has set and established “the rules of the game” for some time, but we are currently in a changing environment in that rates are beginning to climb again.
Being a “glass is half full” kind of guy, let’s start with the good. Given that interest rates are essentially at an all-time low, and quite likely the lowest many of us may see in our lifetime, now is a great time to take advantage of lending. I am not advocating going out and running up credit cards or other bad debt, but the current environment has created great opportunity when it comes to “good debt” financing, such as mortgages. I hear many stories where people’s first mortgage was 11%, and they were happy with that. Imagine a scenario, where a fixed rate mortgage in the realm of 2.99%-4.5% is actually a reality. This is the opportunity I am referring to. For many, our homes are one of the biggest investments we make in our lifetime. Being able to make that investment and give up as little as possible in the form of interest payments to the bank is undoubtedly preferred.
Now, for some of the bad. I have shared this in previous blogs, and I am sure you have seen unfortunate reminders since then on your savings account statements. A low interest rate environment also means you are going to see next to nothing in the form of interest payments to you from the bank. This creates its own issues aside from frustration, in that if you are earning 0.02% in interest, and inflation is running around 3%, you are “safely losing” 2.98%.
That aside, a rising interest rate environment creates challenges when it comes to bonds. To understand the relationship of interest rates and bonds, think of a teeter totter. As interest rates go down, the value of your bonds increase, but as teeter totters work, once rates start to rise, this pushes down on your bonds. Why is this important, and why should you be concerned/aware of this? Well, there are several reasons.
Bonds offer diversification, which is the whole purpose of holding them in a portfolio. You want your bonds to move differently than your stocks at the same time. Simply put, when stocks push down, you want your bonds to create some buoyancy for your portfolio to offset the loss (among other things, but that is for a later date to discuss). The ability of bonds to act as your portfolio’s water wings becomes that much harder in a rising interest rate environment, much more so depending on your bond selection. Thinking back to that teeter totter I brought up earlier, if you choose to hold a lower quality, longer duration bond, or are chasing yield in the form of junk bonds, your bonds are further out on that teeter totter and will be affected much more, than say a shorter duration, higher quality bond. All portfolio tool selection is important, but bond selection is currently paramount unless you are looking for some unfortunate surprises.
Now, for the unknown. The FED recently shared that they plan on holding rates through 2019. While they say this now, that is subject to change. At this point in time, we anticipate they will resume raising rates through 2020. It is unknown if they will maintain this course, how aggressively they will increase them, what inflation’s role is, and what it will do to the markets (generally speaking, the market does not react positively as rates climb). Once our crystal ball comes back from the shop, I will be able to share more.
I will add that ultimately, it is a good thing rates are increasing, assuming they don’t get carried away. I say this because the FED controls the money supply through interest rates, had they not had the ability to “pull back” on that lever and reduce rates during the financial crisis of 2007-2009, that would have been a more devastating event than it already was. Without raising rates, there is little to no “pull” left on that lever the next time it is needed.
As Clint Eastwood shared: “I’ll sleep better knowing my good friend is by my side to protect me”; know that we are by your side.