The Verus Team

Current Interest Rate Environment, Investing, and Framing the Risks

Written by: Derek Majkowski. Any opinions are those of Derek Majkowski and not necessarily those of RJFS or Raymond James.

As I write, the 10 year US Treasury Bond hovers around 1.7%. This is a modest move higher in yield from recently bottoming around 1.45% in August.

This means, if you purchased $10,000 of a 10 year US Treasury Bond in August when the rate was 1.45%, you would collect $145 per year. Based on today’s 10 year US Treasury Bond rate, that’s now approximately $170 per year.

In multiple developed countries around the globe, 10 year Government Bonds are mostly lower than the US Treasury Bond, and some are at a negative interest rate. This means you basically lose money, or pay a Sovereign money each year over the next 10 years in order for them to borrow your funds today.

Dissecting why interest rates are lower is the topic for another article or conversation, and there are many opinions on why rates are trending in this lower direction. There are just as many opinions on where rates will continue to move, and what that ultimately means for future bond prices and stock prices.

Raymond James Doug Drabik, Senior Strategist Fixed Income Services Group, speaks to some of these topics in this article:  https://www.raymondjames.com/commentary-and-insights/markets-investing/2019/09/09/bond-market-commentary.

As you can read, Mr. Drabik highlights the goals of Central Banks to help explain the cutting of interest rates, and some of the nearer-term expectations around monetary policy and the likelihood of further cuts. He also references some of the primary goals around owning individual bonds, and the long-term nature of these investments within a diversified portfolio.

As highlighted in Mr. Drabik’s commentary (and I paraphrase), lower rates are used to jumpstart economic activity. For the individual investor, it means lower rates on your savings or safer fixed income vehicles, and an indirect push to either drive spending, or have investors seek riskier assets in order to improve returns on their respective capital.

Primarily, Mr. Drabik concludes that in this environment it is more important for bond owners to focus on the return of principal vs. the return on principal. While generally accurate and helpful, I do feel it is important to also recognize that most individual bond buyers purchase bonds for both reasons.

In my opinion, the current rate environment challenges a full commitment to bond buying, and forces investors to seek alternatives in order to get both yield and principal return.

To illustrate the yield case first or return on principal, let’s assume a $10K investment in two hypothetical investments. If we are thinking long-term (10 years) with our money in the current interest rate environment, which of the following would you prefer?

Investment A - $10K investment – collect a fixed rate of $170 per year for the next 10 years with return of principal at the end of 10 years. As mentioned, this is very similar to today’s 10 year US Treasury Bond.

Investment B - $10K investment in a vehicle that pays income of $180 a year with some potential upside.

What if I told you that with Investment B over any 10 year rolling period since 1979 your worst 10 year return could be anywhere from a -3% per year return to a +20% per year. This is very similar to the current yield and historic 10 year rolling return on the S&P 500 since 1979.

To dollarize, on a $10K investment in Investment B, and assuming an income stream of $180 per year reinvested, you could see an amount of anywhere between approximately $8950 (-3% per year) up to potentially $66500 (+20% per year) at the end of 10 years.

In Investment A, you would have $10K plus the $1700 received in income over the 10 years. If you assume reinvestment at the same rate, you get approximately $11840 after 10 years.

The question to consider is - are you willing – with those dollars over a 10 year time frame, to own an investment in an instrument that may be down but also provides greater upside; or do you prefer an assured rate of return with little fluctuation?

While the above illustration is very basic, you can see how lower fixed rates over a longer period of time does not appear that compelling when compared to a negative return environment (possibly) over 10 years. This is especially true when you see how much potential upside could possibly be gained. If you change the fixed rate to something like 5% for example, then choosing the riskier asset is not as compelling when weighing the risk and return.

To address the return of principal component of owning bonds, I pose the following hypothetical example based on the current interest rate environment:

Investment A as above – 10K with a fixed rate of 1.7% or $170 a year in income and principal returned fully in 10 years.

Investment(s) C - $5K invested in dividend paying stock yielding 4% or $200 a year with the other $5K in a bank account at .4% or $20 a year. Total income per year = $220 with $5k in the bank available immediately and no principal risk.

Recognizing that the dividend paying stock can fluctuate in value and even lose money if sold lower than where purchased, if we are still assuming a longer term time horizon, which investment(s) provides higher cash flow, more flexibility to the investor, and more liquidity?

When purchasing bonds (in this example a 10 Year US Treasury Bond) and holding to maturity, it is true that you will receive your principal back. Bond prices, however, will fluctuate during their life, up or down, based on the path of future interest rates.

Given this price movement reality in the example above, and with current rates near historically low levels, over the next 10 years, which investment strategy would you rather have? Which one makes you feel more comfortable with your principal? What if the 10 year US Treasury bond is yielding 3% in 5 years? What if rates go the other way and they are .70%?

Again, like the first example, this is another attempt to highlight how the lower rate environment forces us as planners and investors to revisit our rationale for investing in certain vehicles, and framing what our primary goals are, and what risks we are willing to assume or shift elsewhere. While bonds have been defined historically as “safer” investments, these are two comparative examples of where they may not be as compelling over a longer period of time.

This does not mean you can’t or shouldn’t buy bonds, only that there are reasons to ask different questions around why you are buying them, and what you are looking to accomplish, and over what time period. Are there different, potentially better ways, to achieve your objectives?

Whenever we invest, or don’t invest, we assume some form of risk. There is risk in losing money, risk of running out of money, risk of low relative return, opportunity risk, purchase power risk, default risk, timing risk – just to name a few. It is always important to take the temperature on what risks we can and cannot handle.

As investors we need to take into account the current environment in asset prices, interest rates, the types of investment products available, as well as our own personal financial situation. The above is a discussion around the possible choices to be made with money that can be invested for a longer period of time. It assumes that we are adequately addressing our short-term and intermediate term needs and goals prudently.

When we tackle the discussion of Return OF and Return ON our principal, the current rate environment is challenging conventional wisdom, and forcing reevaluating portfolio construction.

 

All examples are hypothetical for illustration purpose only and do not represent an actual investment.

This material is being provided for informational purposes only and is not a complete description, nor is it a recommendation.  Investment mentioned may not be suitable for all investors.  Dividends are not guaranteed and must be authorized by the company’s board of directors.  Investing involves risk and investors may incur a profit or a loss regardless of the strategy selected.  Past performance may not be indicative of future results.

Bond price and yields are subject to change based upon market conditions and availability.  If bonds are sold prior to maturity, you may receive more or less than your initial investment.  There is an inverse relationship between interest rate movements and fixed income prices.  Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.  U.S> government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value.  U.S. government bonds are issued and backed by the full faith and credit of the federal government, to include timely payment of interest and principal.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.  You cannot invest directly in an index.

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