Keeping an Eye on Interest Rates

The Federal Reserve and the monetary policy it pursues is always a matter of interest to investors. The level of intrigue has been particularly acute this year because of growing speculation that the Fed is likely to boost the Fed Funds rate, a short-term interest rate it controls directly, for the first time since 2006.

This creates challenges for investors who may have pursued one investment strategy in a period of declining or stable rates. A different approach might be required if the interest rate environment shifts to one where rates trend higher.

Assessing bond market risk today

Interest rate risk is always a concern for bond investors, but especially when rates are as low as they are today. Rising rates may seem beneficial to fixed income investors who would like to earn higher yields on their savings, but there is a downside. When interest rates rise, the value of bonds already in the market (and potentially held in your portfolio or bond mutual fund) declines. These price declines occur as the bond yields rise to reflect the increase in interest rates. In the long run, the bonds will mature at par, or 100% of their initial value, but in the short run, investors may see a drop in investment values.

For several years, there’s been significant speculation among market analysts that the interest rate environment was due for a change. Consider it from an historical perspective using the yield on the 10-year U.S. Treasury note at constant maturity as a benchmark:

· The yield peaked at 15.84 percent in September 1981.

· Over the next 30 years, yields moved lower, eventually hitting a low of 1.43 percent in July, 2012.

· For the last three years, yields have fluctuated in a fairly wide range, from 1.68 percent to 3.04 percent as investors have digested economic data and Federal Reserve commentaries.

At these current low levels, the general consensus is that rates are likely to move higher, meaning bond portfolios might be at risk of losing value in the near term.

A potential residual effect on stocks

The impact of rising rates on the equity market is typically less direct than it is on the bond market. At times in the past when interest rates have moved higher, it has dampened returns in the stock market. There could be a few reasons for this. With rates moving higher, some investors think bonds are more attractive than stocks. Also, higher rates could potentially dampen borrowing activity, and even contribute to a slowdown in business activity. Of course, there are many other factors that can also affect stocks and businesses besides interest rate movements. Regardless of what happens with rates, your age and investment time horizon have a lot to do with how you make investment decisions. Make sure these decisions are in the long-term interests of achieving your financial objectives.

Positioning for a change

If past market cycles are any guide, it is inevitable that at some point, interest rates will begin to move higher. The biggest questions are when it will start, and how quickly and dramatic the increase will be. While it may not be possible to eliminate all risk from the impact of rising rates, investors should exercise some caution. Now is a good time to consult with a financial professional about how to prepare for potential changes in the investment landscape that would occur if interest rates begin to move higher.

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