Question: Where are interest rates heading? See the answer at the end of the blog.
Let’s look at the future and see how present market conditions impact investment strategies. Here are the factors that are driving the stock market and other investments. They include: The Federal Reserve and the current interest rates. In this blog, we will focus on the direction of interest rates.
In this blog, we will focus on the Feds.
A small increase in interest can have considerably negative results for income securities. Exhibit 4 illustrates yields, maximum returns and the maximum downside for this list of income investments in the last decade:
If you look at the list above, you can see the impact of longer-term securities which include Standard & Poor’s 500, MLPs, U.S. REITs, Preferred stock and U.S. high-yield bonds all had more of a significant downside risk. Shorter-term securities had much less downside.
Interest rates have declined over the past 30 years. Exhibit 5 shows the change in the Ten-Year U.S. Treasury Bonds from 1984-2014:
What does it all mean?
Income Investments have benefited from the trend of the reduction of interest rates. Let’s explore what to expect from income investments from where they are today.
Exhibit 6 shows where we are today and how bonds will act in the coming years, depending on what happens with the interest rates. There are only three possible scenarios: interest rates will go up, they will stay the same, or they will continue to decline.
If they go up, Alan Greenspan was right. If they stay the same, Ben Bernanke was right (and successful). If we enter a period of deflation, Yale economist A. Gary Shilling, is right and we will see deflation. Using Exhibit 6, we will explore each scenario.
What if Interest Rates Rise?
As mentioned earlier, Alan Greenspan said to prepare for double-digit returns in his 2008 book, The Age of Turbulence. As interest rates move up, bonds will move down in value. Many investors are counting on the returns in bonds over the last 30 years to be the same going forward.
How will this effect bonds?
As interest rates go up, bond prices decline. Conversely, as interest rates go down, bond prices increase. Let’s look at bond pricing in two very different markets. For very long-term bonds, there are huge increases of bond value in down markets, like we experienced since 1981. And for very long bonds, the losses will be large in a rising interest environment. To make matters worse if we have a large interest rate movement, both stock and bond markets will more likely move in the same direction: As the long-term interest rates move up, both stock and bond returns could be adversely affected.
The key is not if the long-term interest rates move up, but how fast this happens.
So, why would the Feds want to increase rates? The U. S. Government is the largest pension provider in the world, and if interest rates go up, they will be able to fund their pension liabilities with less money. They will also reduce the costs relating to the U.S Pension Benefit Guaranty Corporation (PBGC) which protects the retirement incomes of more than 44 million American workers. Many are underfunded and PBGC just doesn’t have enough money to bail them all out.
About 25% of these pensions are multi-employer pensions. Kenneth R. Feinberg in June 16, 2015 has been named to oversee a new program to allow certain pension plans to cut retirees’ benefits if that is the only way to keep them from running out of money. You may remember that this is the same person that was placed in charge of the damages with the BP Horizon Spill. Source:www.marketnews.com/content/arbiter-kenneth-feinberg-becomes-us-tsys-pensions-gatekeeper
More than half of multiemployer plan participants will have their benefits reduced if their plans become insolvent and rely on government guarantees in the near future, said a study released Wednesday by the Pension Benefit Guaranty Corp. That compares to 21% of participants now in plans that have already run out of money and rely on PBGC guarantees. It did not include another 64 multi-employer plans that are projected to become insolvent within ten years. Many of the underfunded plans headed toward insolvency or projected to do so within ten years represent plans with larger populations or more generous benefits. Source:www.marketnews.com/content/arbiter-kenneth-feinberg-becomes-us-tsys-pensions-gatekeeper
The study was largely compiled before the Multi-employer Pension Reform Act of 2014 was enacted in December 2014. The new law allows some troubled multiemployer plans to adjust benefits to keep the plan solvent, as long as they remain above the PBGC guarantee level, but it did not change the amount of the PBGC guarantee, which is based on a plan’s benefit accrual rate. “The guarantee itself is going to be less and less effective,” the official said. The study did not factor in the agency’s projection that the multiemployer program will run out of money itself within a decade. Figures released June 17th, 2015 by the Congressional Budget Office project that the PBGC multi-employer fund will be exhausted in 2024.
In Exhibit 7 we show returns in very different markets. We see how the aggregate bond index moves and its impact on five- to seven-year treasury bonds behave in a rising versus a declining aggregate bond interest environment.
From 1953 to 1981 we were in a generally increasing interest rate environment which resulted in average annual aggregate bond returns of 2.48 percent (right scale) and a change of bond values ranging from a loss of 15 percent to a gain of 40 percent (left scale). From 1981 to 2013 we were in a generally decreasing interest rate environment which resulted in average annual aggregate bond returns of 10.74 percent (right scale) and a change of bond value ranging from a loss of 15 percent to a gain 53 percent. Although 2.48 percent isn’t great, it is better than the large losses of long-term bonds in a rising interest rate environment.
In Exhibit 8, consider a three percent ten-year bond, one year after interest rates go up by one percent. If interest rates were to increase by one percent, the ten-year bond drops by 7.5 percent, assuming no other risk factors considered.
With that said, as of July 2016, we do not expect a fast-rising, double-digit interest rate environment likely. We see Alan Greenspan’s book and double digit interest rate prediction as a means of fighting deflation, by highlighting the threat of inflation. We see that most likely there will be small interest increases over longer periods of time, to reduce our pension shortfalls, but not enough to adversely impact the markets.
The longer the bond or income investment, the more loss exposure you have. In this environment, avoid long term investments as they will decline the most. Avoid long-term bond funds like (TLT), (BLV), and REITS (VNQ). Consider using inflation-adjusted bond funds (TIP); commodities like oil (IYE); natural resources (VAW); timber (WOOD); gold (GLD); REITS (RWR); high-yield bond funds (JNK); and Financial Sector ETFs (IYF). Our sector rotation strategy also does well in this environment.
Shorting the Long-term Treasuries (TBT) is also a way to invest in a rising interest environment, but you better be right, as these investments do VERY poorly in any other interest rate environment.
The Asset Allocations that did well in a slightly increasing interest rate environment were Andrew Tobias, Mohamed El-Erian, William Bernstein and Ken Fisher because of the amount they have in equities. The worst performers were David Swensen, theRisk Parity Portfolio and Ray Dalio’s All-Weather Strategy, Ivy Portfolio, and Fail-Safe Investing because of the bond exposures. Much depends on how fast the interest rise occurs: in a fast rising interest rate market, the best place to invest money will be in the safety of extremely short-term, high-quality bonds, CDs and money market.
What if Interest Rates Stay the Same?
If interest rates remain the same, the key is to have higher yielding income investments. Higher yielding investments like REITS, high-yield bonds, the sector rotation strategy, diversified bond funds, stock funds, and commodities all can do well in this environment. That is why the Federal Reserve is trying to maintain a stable interest rate environment. Most managers do well in this environment, except Schiff and Rickards because their key investments do poorly in a moderate environment.
What if Interest Rates Go Down, and We Have Deflation
If we end up having deflation, the best investments are cash and money market. If you are interested in metals, gold (IAU, GLD) historically offers investors a safe-haven during deflationary times. Confine your stock market investing to deflation-proof sectors including Utilities (IDU), Healthcare (IYH) and Agricultural goods (VAW, DBA).
If you are sure that deflation is upon us, consider investing in inverse exchange-traded funds that are designed to profit from the deflating economy like the NASDAQ Short (PSQ). Limit your risk while increasing your bank account balance by investing in Bond Funds (TLT, BND, AGG, and BSV) that offer fixed interest rates in varying denominations. Risk parity and Ray Dalio’s strategy does well in deflation because of the longer term bond positions.
According to our favorite economist, A. Gary Shilling, the Yale economist who correctly called the last seven market corrections, he said to expect deflation in spite of the efforts of the Federal Reserve as sovereign funds and baby-boomers seek yield, which Shilling believes will further depress rates and increase stock and bond values.
Shilling suggests the following twelve sectors to sell or avoid in a deflationary environment: avoid investing in failing or marginal companies, low and non-tech capital producers; commercial real estate in over-built areas; commodities; developing countries’ stocks and bonds; Japan; big-ticket consumer purchase stocks; credit card and other consumer lenders; special homebuilders and suppliers; antiques, art and other intangibles; banks or other financial institutions; and high-yield or junk securities.
We have also attempted to show how our approach will perform in the future and adjust as early on as changes occur. Shilling suggests the following sectors to buy in a deflationary environment: U.S. Treasuries and other quality corporate securities; income producing stocks; food and other consumer staples; the U.S. dollar; investment advisory firms; factory built and rental apartments; healthcare; productivity enhancers; and North American Energy. For more information on Shilling’s perspective read, The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. Source: Wikipedia.com
Answer to the Question: Where are interest rates heading?
We reviewed the impact of the Federal Reserve, the U.S. Dollar, oil, gold and current interest rates on the future of each investment strategy that applies. Specifically, in other blogs and articles we covered the “master plan” of the Federal Reserve and exactly what they plan on doing to battle deflation or inflation.
We expect in the future interest rates to rise albeit at a slow pace, allowing pensions to offload their liabilities with less money and without overburdening the Fed’s pension guarantee fund. Since interest rates are already low and have been low for some time, we do not see much upside opportunity in long-term bonds as they do not do well in a rising interest rate environment. We examined the impact of interest rates in a deflationary, status quo, and the inflationary environment, and how to protect your downside risks.
by: Brett Machtig, & Josh Gronholz
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About the Authors:
Brett Machtig has authored several books and is the founding partner of The Capital Advisory Group, a private asset management and retirement planning services firm located in Bloomington, MN. Their firm manages more than $400 million in assets for 83 institutions and about 850 families as of December 31, 2014. He has been helping affluent investors execute financial strategies, meet income objectives and realize life visions for more than 30 years. Approachable, genuine and down-to-earth, Brett holds himself to a high standard of accountability and seeks to achieve positive financial results on behalf of each client. In this article, Brett shares the effectiveness of each strategy and how to improve it.
Josh Gronholz graduated Summa Cum Laude from the University of Minnesota’s Carlson School of Management and is a Registered Investment Advisor Representative. He has worked in asset modeling with The Capital Advisory Group and has spent the bulk of his career modeling various investment scenarios and assisting individuals along their way to financial success and personal wealth.
(1)finra.org/web/groups/industry/@ip/@reg/@notice/documents/noticecomments/p118980.pdfas of 8/2014
(2) www.sec.gov/divisions/investment/advoverview.htm as of 8/2014
(3) www.fi360.com/products-services/tools-overview, as of 8/2014, Results not guaranteed.
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