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Higher Interest Rates Ahead?

by on December 08, 2013 8:00 AM

We have witnessed nearly a half dozen years of low interest rate policies by our Federal Reserve and related low interest rate policies by the Bank of Japan and the European Central Bank.

Zero Interest Rate Policy (ZIRP) has been followed by Quantitative Easing I and II (both time constrained) and now QE III (no time limit on this round, just a mere $85 billion per month in treasury bond and mortgage purchases) as well as Operation Twist (buying long maturities and selling short maturities to keep long term interest rates low).

So folks who saved for retirement are getting the short end of the political stick which translates to slim to no returns on savings and bonds.

As a result, retirees have looked to stocks to get reasonable cash flow returns to cover their living expenses. The Federal Reserve has forced conservative investors into riskier investments by mispricing the cost of money (too low) and not allowing the market to gauge risk of failure appropriately.

All investors must stay nimble in this environment by maintaining the ability to sell quickly if the situation warrants. Investors must pay attention and follow the daily price movements of their investments to be aware of the changes that are inevitable in the future, be it next year or further into the future.

We got a hint of what might happen when interest rates rise last May when Fed Chair Ben Bernanke indicated they might start tapering on QE III. Interest rates on ten year treasuries jumped from 1.8% to 2.8% and have not returned to the lower levels.

Anyone holding ten year treasuries took a substantial capital loss from which they have not yet recovered. Likewise, municipal bonds dropped about 8.8 to 11.0% in market value (two to three years' of interest returns), and have only marginally recovered. This occurred when it was only hinted that economic policy might change, not when policy actually changed.

So an investor's million dollar portfolio of highly marketable long term municipal bonds would be down $100,000, and the interest return will likely take two to three years to recover this loss. In this same time frame, stock prices dropped 7-9%, fully recovered, and have moved on to substantially higher prices.

The lesson at hand is that once again conservative investors were punished and those that stayed invested in stocks did much better. Buying bonds, annuities and certificates of deposit have been a sucker's bet.

Staying invested in more volatile investments, although nerve-racking, has been the winner lately. This is not to say that always taking the more volatile approach to investments is the better route to employ. Past performance is never an indicator of future results. All investment strategies eventually get old because they eventually fail.

So my advice to investors is to pay attention to your holdings and be ready to move to cash on short notice if interest rates start to rise for whatever reason.

There is no set-and-forget investment that will save you from the turmoil ahead. There is just your ability to make changes in your holdings that will conserve your principal. Higher interest rates will someday return to the investment scene. To be prepared for this eventuality here are my recommended action steps:

1.) Only invest in those things that trade daily and that are priced, so that you can see what is happening and sell if necessary.

2.) Pay attention to your investments daily. A month's vacation touring the rivers of Europe that prevents you from paying attention could be disastrous for your portfolio.

3.) If you cannot pay constant attention to the prices of your holdings, hire someone who can and allow them to be able to protect your nest egg for you by giving them authority to move your investment to cash if needed.

No one in Washington is looking out for your portfolio. They have other policy objectives. It is up to you and your portfolio manager to tiptoe your way through the current investment mine field.

Stay focused, pay attention to your investments, seek help if you need it and make changes as appropriate to protect your net worth.

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Dan Nestlerode is the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. A graduate of Penn State University, Nestlerode has been an investment advisor since 1965. He can be reached at danielj@nestlerode.com.
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