Monday, May 9, 2011

3 Things to Do Before the Fed Raises Interest Rates

Rule No. 1 of investing is "Don't lose money." Investment advisers learn early in their careers, either through formal education or through unfortunate experience, that when interest rates rise,bond prices fall and bond holders lose money.
The past three years have been an anomalous time; never before in U.S. history have interest rates, as controlled by the Federal Reserve, been so low. The Fed  has kept the target rate between 0% and 0.25% since December 2008. This low interest rate strategy was intended to get capital moving and thereby resuscitate the economy.
During difficult times like the "Great Recession," investors get scared into "safer" investments such as bonds and cash. By keeping interest rates artificially low, the government attempts to render bonds and cash less appealing. The low yields are supposed to motivate investors to move money into riskier assets such as stocks. 
U.S. Treasury securities carry the guarantee of the government that the principal will be returned upon maturity. There is no risk of default. This is very popular during uncertain times. But even with the government guarantee, these bonds can lose their luster if the interest rates being paid are very low. Rather than tie up your money in a 10-Year Treasury, which at the time of this writing is paying around 3.5%, you might venture off into the equity markets to hopefully achieve a higher rate of return.
Thanks to low interest rates, infaltion is making a comeback. In the late 1970s and early 1980s, the United States experienced double-digit inflation. Mortgages were written at rates in the high teens and 30-year Treasuries yielded similarly high amounts. It took the nomination of Federal Reserve Chairman Paul Volcker and his bold decision to radically raise interest rates to bring inflation under control. Today, with rates having been kept so low for so long, some are worried that we may yet see levels of inflation not experienced since the 1970s and 1980s.
Federal Reserve policy decisions made during and since the recent financial crisis have worked so far. The stock market is racing to reclaim all-time highs, unemployment is improving and a general sense of optimism is influencing consumer behavior. These factors uniformly point to the need to raise interest rates. It is generally thought that the Fed will act before inflation becomes a problem. Some, including a few Federal Reserve board members, think the Fed should have already acted.
The Fed will inevitably raise interest rates. They can't go any lower. And unless the economic situation worsens, expect the Fed to move sooner rather than later.
When the Fed acts you must be prepared. Whether you own bonds, bond funds or bond exchange-traded funds (ETFs), you have to be prepared to suffer capital losses -- that is, if you don't do something about it.
There are a few things you can do…
1. Sell your interest rate-sensitive positions -- Move to cash. Virtually any marketable fixed-income investment is susceptible to losses in a rising interest rate environment. An existing bond that pays a 3% coupon rate while identical new bonds are being issued at 4% coupons will be less valuable on the open market. For the old bond to be appealing, the price has to decline so that the current yield on the old bond equals the current yield on the new bond. Here's the math for two bonds, both with a $1,000 face value.
The New Bond with a 4% coupon-- $40.00 share price/$1,000 face value = 4% current yield with a $1,000 Market value Bond with a 3% coupon -- $30.00 share price/$750 = 4% current yield with a $750.00 Market Value
In other words, the old bond would be worth 25% less -- $750 compared with a $1,000.00 face value. At that price level an equivalent current yield is achieved. This applies to bond funds as well. The entire portfolio of a bond fund can be susceptible to such declines.
2. Buy investments that benefit from rising inflation -- If inflation is rising or is expected to rise, then you should have some exposure to Treasury Inflation Protected Securities (TIPS). TIPS increase in value relative to the rate of inflation as measured by the Consumer Price Index (CPI). These can be purchased as individual bonds or in mutual funds. My preference is using ETFs such as the iShares Barclays TIPS Bond Fund (NYSE: TIP), which has a 0.20% management fee and a current yield of 2.76%.
3. Invest in things that go up when bonds go down -- This is my favorite option because it is the most direct way to benefit from a decline in bond prices. There has been much written about a "treasury bubble." Massive amounts of money was pumped into treasuries as investors ran away from risk and into safety and as the government bought treasuries as part of QE2 (Quantitative Easing Part 2).
As the economy and the markets continue to improve and once QE2 ends (its scheduled to end in June this year) there will be significantly less demand for treasuries, and prices should fall. Bill Gross, the manager of the largest bond fund in the world, the PIMCO Total Return Fund (Nasdaq: PTTAX), is very worried about treasury prices falling. He's so concerned, he's sold ALL of the treasuries from his $236 billion fund.
I suggest the ProShares Short 20+ Year Treasury (NYSE: TBF) ETF or the ProShares Ultra Short 20+ Year Treasury (NYSE: TBTETF. [StreetAuthority's Amy Calistri recommends these funds for her Stocks of the Month readers, too.] These funds go up as treasury prices go down. Be cautious with the ultra-short version, it will be more volatile and that means a greater chance of loss. Of course that also means greater potential profits.
Action to Take --> Bottom line: Do something. Interest rates will rise, bond prices will fall and you can choose to lose, preserve -- or profit.

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