2018-10-11 Our Rising Interest Rate Environment
[AUDIO INTRODUCTION] Welcome to the Bryn Mawr Trust Wealth Management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, president of BMT Wealth Management.
[SPEAKER: JEN FOX] Hello, everyone. Today we’re discussing the interest rate environment here in the United States. I’m meeting with Jim Barnes, director of fixed income with BMT Wealth Management. Jim, welcome.
[SPEAKER: JIM BARNES] Thanks, Jen.
[SPEAKER: JEN FOX] Jim, the interest rate environment looks a little different today than it did a couple of years ago. Money market rates, bond yields, mortgage rates, et cetera have risen quite a bit. What’s been the primary driver?
[SPEAKER: JIM BARNES] Primary driver– I would point to both strong economic growth, as well as the Federal Reserve’s overall response to that growth. After many years of such historically low interest rates, the Federal Reserve began gradually raising the federal funds target range back in December 2015.
Now, this target range is the primary tool that the Federal Reserve will use to conduct its overall monetary policy. So when the Fed wants to provide additional stimulus to promote economic growth, it will generally keep this range purposely low. However, when the Fed is comfortable with the overall economic outlook, the need for this stimulus subsides. And interest rates can revert back to a higher level, something that is a little less accommodative.
So so far, the Fed began embarking on interest rates back in late 2015, as I noted. The target range then was right around 0% but has since raised 200 basis points to its current 2% to 2.25%.
[SPEAKER: JEN FOX] Jim, should our clients be concerned that the Fed is raising rates?
[SPEAKER: JIM BARNES] I don’t think so. When the Federal Reserve is looking to stimulate economic growth, it wants low interest rates to spur consumer and business borrowing and spending. So to use an analogy for comparison purposes, when you’re providing medicine to a sick patient to get them back on their feet again, once the patient is healed, there’s no need to provide any further medicine. When you look at US economic growth that has grown 2% each year on an average basis over the last eight, nine years or so and expected to be about 3% or so this year, you just simply don’t need that much medicine.
[SPEAKER: JEN FOX] So that makes sense to me– strong economy warrants higher rates. But if you’re a bond investor, don’t higher rates mean lower bond prices?
[SPEAKER: JIM BARNES] Lower bond prices, yes, but not necessarily negative returns. And there’s an important difference between the two. Bond investors purchasing par bonds earn the return from two sources. They earn it from the cash received from the coupon payment, as well as any changes in the price of bond if it’s sold prior to maturity.
Now, if the bond is actually held to maturity, the investor will receive the original par amount that they invested. So if the intention is to hold the bond to maturity, the price will fluctuate during the investment period. At maturity, however, the price would be par.
Now, this is important because if higher interest rates lead to lower bond prices, at some point, the bond price has to gravitate back towards par. In the end, the investor’s return will be driven primarily by the coupon payments received.
[SPEAKER: JEN FOX] So the buy-and-hold investor will earn the coupon payment.
[SPEAKER: JIM BARNES] That’s correct. And at maturity, the proceeds can be reinvested in a new bond paying a higher coupon. So for buy-and-hold investors, you actually want higher interest rates because it provides more opportunity for the portfolio to earn additional income over time.
[SPEAKER: JEN FOX] So Jim, what would happen if I’m in a situation where I need to sell the bond prior to maturity?
[SPEAKER: JIM BARNES] Well, if the bond is sold prior to maturity at a price below par, the investor will incur a realized loss. And if the coupon payments received aren’t enough to offset the loss, this is when the bond will have a negative return.
[SPEAKER: JEN FOX] So it would seem to me that I would need to plan a little bit better on cash, though, because then why would I ever want to sell prior to maturity?
[SPEAKER: JIM BARNES] Very good question. So going back to the two sources of a bond’s return, for bonds purchased at par, it is a coupon interest and the difference between the purchase and the selling price of the bond. So investors purposely selling the bond at a loss are most likely looking to take advantage at the higher interest rate environment. As you noted earlier, bond prices drop when interest rates rise.
So the investor is willing to sell their investment at a price below par so that the proceeds can be reinvested in a new bond paying a higher coupon payment. The amount that the investor loses due to price depreciation will be offset by the higher coupon payments received over time, or at least that is the goal. The size of the loss and the additional coupon interest received will determine how long it will take the investor to recoup his or her investment losses.
[SPEAKER: JEN FOX] So am I right in assuming that you’re referring to an actively managed bond portfolio?
[SPEAKER: JIM BARNES] That’s correct. There are generally two approaches for bond investing. There’s buy and hold. And then there’s also a more active approach. Now, there are many things to consider when determining the best strategy for an investor– liquidity needs, time horizon, tax situation, et cetera. For now, our discussion has generally focused on the difference between the two strategies and a rising interest rate environment.
[SPEAKER: JEN FOX] Excellent. So now that we’ve gone through the strategies, what are your thoughts for interest rates going forward?
[SPEAKER: JIM BARNES] Well, I do think that the Fed will remain on course to raise interest rates a few more times over the next 18 months or so. We have to keep in mind, though, that historically, interest rates are still on the low side, while the US economy is growing at a very, very healthy pace.
Now, of course, there are going to be a handful of concerns– trade wars, emerging market weakness, tariffs, just to name a few. They could have a negative impact to some extent on the US economy. Now, however, high interest rates seem appropriate. It’s important to note, though, that the Fed is not on a preset course. They can certainly alter its direction if something unexpected were to occur to derail the ongoing economic expansion.
[SPEAKER: JEN FOX] Jim, thanks so much for walking us through the complicated world of bonds and investing. You’ve made a very complicated subject easy to understand.
[SPEAKER: JIM BARNES] Happy to do it, Jen. Thanks for giving me the opportunity.
[AUDIO CONCLUSION/CLOSE] This has been a production of Bryn Mawr Trust, copyright 2018, all rights reserved. Visit us online at bmtc.com/wealth.
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