Understanding Interest Rates and Bond Prices
The Federal Reserve has announced that they are going to be raising interest rates a number of times this year. This past week, they took the first step to raise about 25 basis points. We're eventually expecting anywhere from 4% to 7%-8% on the high side. This year, we will likely only see 4%-5% total on the federal funds rate.
Preparing for an Inverted Yield Curve
Now, remember, the Federal Reserve only controls the "overnight rate" for banks. They don't control what happens with a 10-year mortgage, a 20-year mortgage, 30-year mortgage. They just control the overnight rate. Still, what we've seen historically is that as the short-term rate goes up, the longer-term rates tend to trend up as well.
We've all seen this pattern - after long periods of very, very low rates, the Federal Reserve will raise rates. Specifically, they implement what's called an "inverted yield curve" - when short-term rates are actually higher than long-term rates.
Why does this matter? Because there is a high correlation between an inverted yield curve and periods of recession or periods of economic contraction.
Managing the Growth Rate on the Economy
The Federal Reserve is trying to do is control the growth rate of the economy. There are a whole bunch of factors - like supply chains and COVID fallout - causing inflation. Together, they're overheating our economy right now.
As the Federal Reserve raises interest rates to manage the overheating, another cause-and-effect comes into play. You may remember the old principle, "When interest rates go down, bond values go up.” Well, the opposite is also true, when interest rates go up, bond values go down.
When it comes to your portfolio, here's what you need to know. This market dynamic means the things that we've done historically to be safe (bond indexes, 10-year T-bills, etc) are not going to be great investments for the time being and probably for the foreseeable future.
Depending on the length of your bond (5-year, 10-year, 30-year, and so forth), the changes in interest rates will have varied impacts on the valuation of your bonds.
Four Steps We're Taking to Protect Your Portfolio
With the economic stage set, I want to talk about four things that we have already done and are currently doing within your portfolio. These four steps are focused on the conservative end of your investment portfolio to try to protect against the fluctuations in interest rates.
1. We use cash T-bills.
We use cash T-bills. If you look in your portfolio, you probably see a position called "GBIL". GBIL is a one-year T-bill. You also have cash in your portfolio with us.
The cash levels have been running higher than typical. Why? Because we knew this was coming. We wanted to protect against that preemptively. We also want to have dry powder for fluctuation in the market so that we can buy.
2. Fixed Index Annuities
Most of our clients have at least a portion of their portfolio in fixed index annuities. These are investment vehicles that have no internal fees and no downside risk. Even as interest rates go up, you can't lose money in a fixed index annuity because they're backed up by the insurance company.
3. High-yield Municipal Bonds
These are bonds in municipalities that are traditionally having disruption or issues and are very cash-strapped. The reason we buy those bonds is that we buy them while they are in crisis, then we hold on while the municipalities go through the process of fixing things.
We usually have them bought at significant discounts and their value is more tied to the actual structural improvements than interest rates. It provides us a measure of insulation from volatility driven by interest rates.
4. Floating-Rate Bonds
Floating-rate bonds have a 90-day duration. These bonds actually change. They adjust their interest rate because it "floats" with the market every 90 days. While we typically get very, very low-interest payouts on these, we don't have the long-term fluctuation associated with interest rates.
Safeguarding Your Financial Plan
Those are the four positions that most of our clients own at least a little bit of across their portfolios. They represent the actions we are preemptively taking to make sure that you are not fully exposed to interest rate rises that are now happening.
If you have questions on this or anything else, please call us at any time. We're always here with perspective for the decisions ahead.