It takes hundreds of good golf shots to gain confidence, but only one bad one to lose it” – Jack Nicklaus

An entire generation of investors has been misled about interest rates; where they come from, what they mean, how they’re determined.

We’ve been getting lots of questions about bonds and the unrest with interest rate hikes going up too far too fast.  So, I thought this month would be a good opportunity to help the Pacific NW PGA section get a handle on understanding a portion of the bond markets.  This is not an attempt to recommend bonds or bond funds.  Merely to dispel the hysteria and to avoid tying your money up for years while inflation and opportunity loss eat away at your otherwise potential wealth creation.

Much of this confusion has to do with the role of central banks.  Many think central banks, like the Fed, control all interest rates.  This isn’t true.  They can only control short-term rates.  It’s true these can have an impact on other rates, but it doesn’t mean they control the entire yield curve which many of us have heard about the past few months.  Beware the flattening yield curve, right.

Ultimately, an interest rate is simply the cost of transferring consumption over time.  If someone wants to save (spend less than they earn today) in order to consume more in the future, they must find someone else who wants to spend more today that they earn and who will repay it in the future.

Savers (lenders) want to be compensated by maintaining – or improving – their future purchasing power, which means they need payment for three things. 1) inflation 2) credit risk 3) taxes.

Lenders deserve compensation for inflation.  Credit risk ….or the chance a loan will not be repaid….is also part of any interest rate.  And those who earn interest owe taxes on that income.  After taxes are paid, investors deserve a positive return.  In other words, interest rates that naturally occur in a competitive marketplace should include these three factors.

So, why haven’t they?  Back in July 2012, the 10-year Treasury yield averaged just 1.53%.  But since then, annual inflation (consumer price index or CPI) has been just about that same number at 1.5%.  Add in one of the other factors, tax, so let’s say you paid a 25% tax rate or 0.383% of the 1.53% yield in taxes.  In other words, after inflation and taxes (and without even thinking about credit risk, which is pretty much nil in the case of a Treasury (but much more in the case of other high duration, high yield, corporates, etc) someone who bought a 10-year bond in July of 2012 has LOST 0.35% of purchasing power each and every year, in addition to capital losses as bond prices have been in decline.

Something is definitely off as the reporters are expressing in the news.  The bond market has not been compensating investors for saving, it has been punishing them.

Some blame Quantitative Easing.  The theory goes, that when the Fed buys bonds, yields fall.  It’s simply supply and demand.  But this is where the misunderstanding lies.  Bonds are not like commodities, where if someone buys up all the steel, the price will move higher.  A bond is a bond, no matter how many exist.  Just because Apple has more bonds outstanding than a small cap company, it doesn’t mean Apple pays a higher interest rate.

If the Fed bought up every 10-year Treasury in existence except for a single $10,000 Note, why would its yield be less than the current yield on the 10-year Note?  It’s the same issuer, same inflation rate, same tax rate, same credit risk, and the same maturity and coupon.  It should have the same yield.  It didn’t become a collector’s item; it still faces competition from a wide array of other investments.  It’s still the same bond.

The real reason interest rates have remained so low is because many think the Fed will keep holding short-term rates down below fundamental levels well into the future.  The Fed’s zero percent interest rate policy artificially held down longer-term Treasury yields, not Quantitative Easing.  If the Fed promises to hold the overnight rate at zero for 2-years then the 2-year Treasury will also be close to zero.  And since the 10-year Note is made up of five continuous 2-year Notes, then Fed policy can influence (but not control) longer-term yields as well.  That’s why longer-term yields have risen as the Fed has hiked rates.  And they will continue to rise.  Why?  Because the Fed has held short-term rates too low for too long.  Interest rates are below inflation and well below nominal GDP growth.  The Fed has gotten away with this for quite some time because they over-regulated banks, making it harder for the banks to lend and grow.  Those days are ending and low rates now are becoming dangerous.

With inflation and growth rising, and regulation on the decline, interest rates must go higher.  They are going up because the economy is telling savers that they should demand higher rates.

 

Blake Parrish, CFP®
Senior VP, Portfolio Manager
Phone: (503) 619-7237
E-mail: blake@bpfinancialassoc.com

Certified Financial Planner Boardof Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.”