Wednesday, February 16, 2011

Interest Rate Risk, What it Means to You.

Interest rates are likely to be rising in 2011. Here’s a primer on interest rates and the affects of interest rate risk on

your investment portfolio.

There’s been quite a bit of hand wringing over municipal bonds in the press lately, specifically around the issue of interest rate risk and it’s affect

on your investment portfolio. These developments should come as no surprise to readers of our blog and readers of my newsletters over last 18

months. I’ve been suggesting for some time that interest rates cannot remain at historic lows indefinitely, and that an actual policy change by the

Federal Reserve isn’t needed to cause a significant move in the bond markets. To wit, that’s exactly what’s happening in the bond markets right now.

To begin, we to need to identify what role fixed income vehicles (bonds) play in your investment portfolio. If you’re at or near retirement, municipal

bonds should be acting as agents of capital preservation. Not as vehicles of growth or speculation. Municipal bonds also provide a tax-free income stream,

according to the coupon. Investment grade bonds purchased in the last 2 years typically carry a coupon of 4.00% or lower. A $100,000 bond with a 4.00%

coupon provides you with $4,000 in annual tax-free income. However, interest rates got so low in 2009-2010, that in order to receive an investment grade bond

with a 4.00% coupon, that wasn’t set to mature in 2055, investors often paid a very handsome premium. $100,000 worth of bonds often cost $114,000 or more.

When we pay a premium, that is paying more than the $100 per bond par value, we incur interest rate risk. That’s because bonds always mature at par, or

$100 per bond. Hence, should rates begin to rise, you could have a built-in $14,000 loss.  

Here’s where it gets tricky. The bond markets are not retail markets. That’s a critical distinction, because, unlike stocks, there is no electronic market place

ready to accept a sell order at the stroke of a key. Any individual bond is really only worth what someone else is willing to pay for it. Bonds prices are a function

of several things, but most importantly, credit quality, and, that’s right, interest rates. And, make no mistake, bond traders operate with a No Prisoners mentality.   

Bids on bonds will move instantly at the slightest notion that rates may be changing, well in advance of an actual Fed policy shift. Furthermore, rates now only have

one place to go, and that’s higher. If you hold a bond with a 4.00% coupon, and bonds are now available in the marketplace with a 5.00% coupon, by definition

your 4.00% bond is worth less than it was before. If you paid a significant premium for that 4.00% bond, you now understand interest rate risk. Yes, you should

receive $100,000 in principal back at maturity, but that $14,000 premium is gone. It also leads to some unattractive numbers in parenthesis on your monthly statement,

we’ve found that clients usually don’t like that.   

This brings us to credit quality, what does investment grade mean? Typically bonds rated BBB or better are said to be investment grade. My clients at Fusion rarely,

if ever, traffic outside A-AAA ratings in the municipal markets. Further, muni bonds are said to be insured when the issuer purchases default insurance, often provided

by, among others, AMBAC or MBIA. The credibility of these insurers was badly damaged during the debt crisis, when numerous offerings said to be “investment grade”

defaulted. Now, stronger issuers often forego insurance and issue debt based solely on their perceived financial strength. To clarify, investors trafficking outside the investment

grade arena do so for reasons other than capital preservation. Speculating on credit quality and interest rates is not part of our portfolio management philosophy at Fusion.         

 

Working around interest rate risk isn’t impossible, and we don’t want to eliminate bonds entirely from our investment strategy. There are two ways we can address this challenge

in the portfolio. First, we can use a standard bond ladder, and second, we can buy shorter maturity bonds. With a ladder strategy, bonds should mature at regular intervals, typically

annually. We should then have the opportunity to reinvest in a more attractive interest rate environment. Second, buying shorter maturity bonds limits our interest rate risk

downside. Bonds closer to maturity aren’t as vulnerable, since they will mature in the near future. The catch, shorter bonds pay lower coupons, which is the trade off for taking less

risk. Alarmist media and uninformed TV anchors aside, if you’re not sure why your bond portfolio is behaving badly, it may be time for a portfolio review and some estate planning.

Best Regards,

Russell Brewer, Partner

Fusion Analytics Investment Partners  

rbrewer@fusioninvest.com

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