For the better part of the last 30 years interest rates have been on a downward sloping trajectory. Going back to finance 101, we know that when interest rates go down, the prices of bonds go up. So while we have had many short term rallies in rates (most notable in the 90’s to cool off the tech bubble), the overall trend for bond prices has been positive. Until recently it seemed that sentiment and trend would continue on in perpetuity.
Then Federal Reserve chairman Ben Bernanke decided the party was getting a little loud and knocked on the door to tell everyone to “turn it down” a little. Specifically Bernanke alluded to the fact the the governments policy of quantitative easing, or Wall St jargon for buying bonds to keep prices high and interest rates low, was coming to an end. The news shook the bond markets in a big way with bellwether tracking indexes falling sharply. As a ripple effect of the news the Feds policy was now going to change, US stocks sold off for fear of slower growth.
What is an investor to do you ask? While stocks have provided plenty of opportunities in recent years it hasn’t been without volatility and some rough seas. Investors who have fled stocks looking for the safe harbor of bonds now face a new dilemma. While owning individual bonds outright will pay annual interest payments, the principal value is subject to significant downside. Holding a particular bond issue to maturity, assuming creditworthiness of the issuer is maintained, will pay back the face value of the bond. But what if those bonds decrease in value by 10,20 or even 30% and you have an unforeseen capital need. Being forced to liquidate to meet that financial need may not be optimal and even equivalent to buying high and selling low. The theory of socking away conservative money in stable bonds to collect worry-free income, even at these low interest rates, has now officially been challenged.
Having a strategy in place that can counter the negative effects of rising interest rates, and using the opportunities when available to lock in higher rates can help insulate from financial ruin. Its like turning around the Titanic. Whiles it is not easy to do, if you have the right technology, experience and insight to correctly map out this foggy landscape of rising interest rates, you can potentially avoid the big disaster.