Interest Rates

Above is a chart of iShares 20+ Year Treasury ETF {TLT-no positions}.  Year to date it has declined on a price basis 8.25% and is down over 16% from its highs at the end of January.  My research of longer dated bond funds shows they have declined between 10 and 15% year to date and have seen declines between 15 and 20% from their highs.  These of course is because interest rates have backed up in anticipation of coming US interest rate hikes, largely expected to start in September.  Interest rates are climbing because the Federal Reserve finally thinks it's seeing enough evidence of a stronger economy that it's time to put away the loose money purse strings.  Most call this the normalization of interest rates .  According to Dr. Ed Yardeni that normalization has been very abrupt.  

Folks looking for yield have piled into bond funds and bond ETFs over the past several years as interest rates have collapsed.  That strategy worked as long as interest rates were held at historically low levels.  The flaw in that thinking always was that interest rates never had any further room to fall and investors in these funds were very vulnerable to capital declines when rates began to move the other way.  In a laddered portfolio of bonds {Basically a bond portfolio designed so that you hold various levels of maturities with a certain percentage of these bonds coming due each year.} you accepted these moves because you know that the maturing bonds should allow you to invest when they come due at higher rates.  Investors have largely shunned owning individual bonds in favor of open ended bond funds, either mutual funds or ETFs.  The reason for this is the yields at the front end of the curve, that is the yields on bonds maturing in the near future, say 1-10 years have been too low for most investors looking for income.  The problem with open end funds {both mutual funds and ETFs} is that these type of funds have no termination date so investors cannot rely on an ultimate maturity date to bail them out.   As such the losses here have the potential to compound, particularly if rates continue to rise,  owing to the open nature of the funds.   If you therefore believe that bond funds are less risky than the stock market then just take a look at what's happened in the last couple of months.

More ink has been spilled and more airtime on financial stations been devoted to when interest rates will rise then I think any other story this year save for the ongoing drama out of Greece.  Wall Street consensus seems to be that rates will begin to rise in September.  One should note that increase is expected to be 25 basis points or 1/4 of one percent.  Most see rates backing up by 50 to 75 basis points over the course of the next year.  From my perch that's not enough to shackle the economy and shouldn't be an impediment to economic growth.  I don't think folks are going to quit buying cars when financing one goes from 0% to 1% for example.  I also don't think that a rising rate environment is a serious threat to stock prices.  The stock market may not go up from here and we could even see volatility increase over the next year or so.  Stocks have their own issues with valuation and the like.  But when I started in the business interest rates were much higher than they are today.  Money market accounts yielded over 8% back then!  Stocks traded most of the time with Price to Earnings Ratios {PE} of 14-16 and higher rates didn't stop the bull markets of the 80s and 90s from occurring.  It's hard for me to imagine an environment where low rates albeit rates slightly higher than where they are today act as a significant break on market returns.  I don't know where the market's going in terms of price but in my opinion if stocks decline the primary culprit won't be the bond markets.  I'll blame slower economic growth, a problem overseas or historically high valuations first.  For my part I think at least in the short term the back up in rates may be a bit over done.  

We've therefore started to pick at certain things where we think there's attractive yields and also further appreciation for growth.  Those investments of course are dependent on our investment strategies and client's individual risk/reward criteria.

Back at the beginning of the week.