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Rising Interest Rates: The Good, Bad & Ugly

The historically low interest rate environment which we’ve inhabited for the last several years has created both  winners and losers, but very few people know which side they’re on, and even fewer know where they will be when interest rates rise.

Word of mouth and general media coverage have touted the benefits of lower interest rates:  the federal deficit is lower than it might otherwise be because the interest on our national debt is low; and the average mortgage borrower has benefited assuming he or she could refinance and lock-in one of these low rates for 15, 20 or 30 years.  Other winners include those investors whose portfolios contained bonds which were purchased at the “old”, higher interest rates.  As rates have fallen, the value of these old bonds has appreciated.  In many cases, these investors have seen gains of as much as 50% over the last 5 years – not from the interest they were paid, but from the appreciation in the value of these old bonds.

But what about the losers?  Few people pay attention to those who depend on the interest from bonds for the lion’s share of their retirement.  Take the case of Fred Yeager or Ellen Keller, both of whom were the subject of a recent Wall Street Journal article on the affects of low interest rates on retirees.  Fred is 91 years old and never thought he’d outlive his retirement money.  As rates have fallen, so too has his income.  “It hurts”, he explains as he estimates that his current withdrawal rate will deplete his assets in about 6 years.  The last thing he wanted at this stage of his life was to be in a race to the end against his retirement account.

Ellen Keller finds herself in similar circumstances.  She actually took early retirement when rates were higher, when her back-of-the-napkin calculations indicated she’d be OK.  Today’s low rates have her “scared to death” and facing the prospect that she may have to rely exclusively on social security.

These aren’t isolated cases.  According to the most recent data available from the Labor Department, the average annual investment income for Americans 65 years or older has decreased 34% from 2007.  The Employee Benefit Research Institute released a survey indicating that one third of retirees have had to dip deeper into their nest eggs than they had ever planned.

The problem for many of these people, those who have been on the losing end of the drop in interest rates, is that many of them are compounding their errors.  The recent gyrations in the stock market have pushed many to abandon equities in hopes of finding greater security in bonds.  This creates two new problems.

First, the greater concentration in bonds means that more of their portfolios will now be subject to the very investment category which is likely to suffer the worst losses in the near-term.  As interest rates begin to rise, the value of existing bonds will fall, and the longer the term of the bond, the greater will be the loss in value.  Even assuming that investors have fled to the highest credit rated bonds, those with a 5 year duration will see a 5% decrease in value for every 1% rise in rates.  Those with a 10 year duration will see a 10% drop in value.  If rates go up 2% – as is likely the case on even a conservative basis – these investors could see 10% to 20% losses in their bond portfolios.

The second problem only compounds the first.  Many of these investors, seeing the low interest rates they were being paid in these “safe” high credit rated bonds, have been tempted to move to longer durations and/or to slightly lower rated bonds.  The longer the bond duration and/or the lower the credit rating, the higher is the interest rate usually paid by the bond.  In order to “get more interest” some investors have stretched out to junk bonds or to 20-year, or even 30-year bonds.  We’ve even had some prospective clients show us portfolios with bonds maturing in 2039.  When rates rise, these types of bonds will create a much more significant problem than the one they were supposed to solve.

The true solution for retirees, or for anyone trying to balance income, growth and retirement needs, is not to abandon bonds, any more than the solution in 2008 and 2009 was to abandon equities.  The solution is to maintain an appropriate bond allocation for your risk tolerance, but to move the types of bonds in that portfolio more toward shorter durations and up toward the higher credit ratings available.  To supplement the traditional income that comes from bonds, some portion of the equities in the portfolio should be skewed toward strong consistent dividend payers.

Of course, there’s more to the ideal, or even appropriate, portfolio allocation than can be discussed in a brief article.  That’s where unbiased financial advice can be invaluable.  The main point here is that all too often investors look only at primary immediate affects, and in so doing ignore the secondary affects, of one solution to one problem.  There are almost always multiple issues to be addressed, and balancing them is the key.  Successful investing is not restricted to the “insiders” or to a handful of elites on Wall Street.  The average investor can succeed, and often wildly so.  It just takes patience and reasoning beyond the panic or the boom of the moment.

“Time is your friend; impulse is your enemy.”  John C. Bogle