There’s upside to higher interest rates
How much would you pay for a dollar of income? Most people would prefer to pay less. Whether it’s buying a business, a bond, a CD, or just putting money into a savings account, people like to get more for less.
How do you feel about higher mortgage rates? Silly question. We all locked in at the lowest rate that we could. Higher interest on a car loan? Lower, please and thank you.
As consumers, we have eagerly anticipated interest rates dropping since the early 1980s. But we are investors, as well. Most of us have some bonds (or bond mutual funds) somewhere in our investments. Bond prices go up as bond yields (interest rates) go down. For people under roughly 35 years of age, this is the only reality they have ever known. So what does this actually mean? (I promise not to make you fall asleep in the next paragraph with long calculations!)
If I offer you a legal contract to borrow $100 for a period of time — say, 10 years — and I will pay you $5 interest per year each year, and then return the $100 at the end, it’s 5%. That sounds good, so you take the contract. Next year, someone else comes along and offers you $6 per year for nine years to borrow that same $100. That’s a better deal. Six percent is more than 5%, simple grade school math. But I’ve already got your $100 and you are tapped out. You have to sell the contract that you made with me to get your money back. How much is the first contract now worth? The simple answer is less. That contract will pay $45 until you get your money back, while the new borrower will pay you $54 over the same period. Whoever buys the contract from you will now pay you proportionately less to make up the difference.
This is how we feel about the current bond market situation. How many people will it affect and just how much money are we talking about? The Wall Street Journal put the total U.S. bond market value at $39 trillion at the end of 2014. By comparison, the U.S. stock market was at $26.3 trillion at that time.1
This isn’t all bad, nor is it all good. What should investors holding bonds do? Do you hold your nose and sell at a loss? Do you simply hold the bond to the end of the loan (maturity) at a low interest rate? Most of us hold bond mutual funds and we let fund managers make the decision on our behalf.
Bonds are frequently held as the “conservative” investment. They frequently have some kind of collateral, which means that if the company behind the bond goes under then the bond has something backing the loan. Bondholders get paid back before the stockholders of the company in the event of a bankruptcy or failure. So, bonds are typically an investment choice in retirement for generating income. However, with low interest rates comes low income. The upside of raising interest rates is that if interest rates rise to a level higher than today, retirees would have a higher income payment based on a less risky investment.
Alex Pudlo is an investment advisor representative for Triumph Wealth Management, where Nathan Brinkman serves as owner and president. Securities, investment advisory, and financial planning services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC 525 Junction Road, Suite 8100 North, Madison, WI 53717 (608) 829-0015. Triumph Wealth Management is not an affiliate or subsidiary of MML Investors Services, LLC, or its affiliated companies. CRN201901-207254
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