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Interest rates carry a certain risk for fixed-income investors. In this two-part article, Ron Redfield, CPA, PFS, addresses the importance of interest rates in your financial planning.
Full Article - Table of Contents
This question deals with the importance of "safety". Many people have viewed CD"s as being the best of both worlds: "risk-free" in the sense that they couldn't lose their money, yet also worthwhile because interest rates were decent. Now interest rates for even long-term CD's can barely keep up with inflation.
If people are still risk-adverse in the sense that they are not ready to invest heavily in the stock market—but they need to get a better return than conventional tools now provide—where should they put their money?
Answer by Ron Redfield (continued from Part 1): Inflation is another risk to quality fixed income investing. Remember during the late 70’s, inflation was much higher than it is now. Hence, interest rates were higher, mortgage rates were much higher, and Money Markets were paying in the mid teens.
The real return to the investor is the difference between interest rates and inflation rates. You can see in today’s environment that a guaranteed investment can yield only a slight difference between interest rates and inflation rates (interest rates less inflation rates).
Volatility of interest rates also has a definite effect on the value of fixed income. Many investors have difficulty understanding that the direction of interest rates has an inverse relationship to the current value of their fixed income investment.
Here is an example.
Assume that you bought a 10-year treasury a month ago and the yield was 3.20%. Hence if you invested $100,000 on June 15, 2003, the US Government has promised to give you back your $100,000 on June 15, 2013. The government will also pay you $3200 per year in interest.
Now this gets interesting. Today the same 10-year bond yields 4.20%. Interestingly enough, the bond you paid $100,000 for 6 weeks ago, is probably now worth around $95,000. That is an unrealized loss of 5% in merely six weeks.
The reason for this is that you can now generate accumulated interest of $42,000 instead of $32,000 over the next 10 years; hence the value of the 3.20% bond has decreased in current value.
How is that for safety? The inverse of that, of course, is also relevant as we witnessed an incredible bull market of quality fixed income portfolios over the last three years.
I think that an investor looking for pure safety needs to consult a competent investment advisor. An investor in safety needs to realize and understand the risks of fixed income investing. We try to dive into both the investors risk tolerance profile and also try to determine that the risk profile is also in sync with the investor’s needs. This is important in all types of investing and certainly in quality fixed income investing.
We try to balance our quality fixed income investments. We often buy quality bonds outside of the US, along with heavy concentrations of US Government obligations. We try to understand the environment of interest rates, yet we acknowledge that we will never predict the movement of interest rates with any type of precision.
Over the last two years, we have balanced our safety minded portfolios with some theoretical inflation hedges and investments, which prospered during the weakness of the US dollar. Please keep in mind that those positions were mentioned as historical in nature, and are not necessarily our strategies in the current environment.
Ronald R. Redfield, CPA, PFS, is available for a free consultation and sample portfolio based on your investment risk tolerance levels. And you're warmly invited to request a complementary copy of Ron's text on investment philosophy.
Please contact Ron by visiting him at Redfield, Blonsky & Co., sending him an email, or calling him at 1 (908) 276-7226. Be sure and read Ron's latest commentary on financial investments, to keep up with market changes.