An updated look at interest rates

September 13, 2010
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At the end of March I wrote about the possibility that interest rates might be ready to break out of the range where they had been trading for the past few years. I took a little poetic license with our bands, concluding that for most of 2003-2005, the 10-year Treasury traded in a range of 4.0 percent to 4.5 percent with modest temporary overshoots on both the upside and downside. From 2006-2007, this band moved up to a 4.5 percent to 5.0 percent range, in large part because of a strong economy, a strong stock market and the need to pay higher rates to attract investors. Weakening conditions caused that band to move down to a 3.4 percent to 3.9 percent range in 2008 before the bottom fell out of the financial markets and a flight to quality caused a major decline in rates. In the middle of 2009, we moved right back into that pre-crisis band and have remained there ever since.

At the time that was written, sentiment about the economy had become more hopeful after a year-long stock market rally, significantly better corporate earnings and a variety of improving economic indicators. The bond market appeared poised for interest rates to move higher.

What a difference a few months can make! Since April, investors have been coping with a long and seemingly unending sequence of negative events. Debt troubles in Europe, the massive oil spill in the Gulf of Mexico, mixed economic news from the U.S., and fears of new financial regulations coming out of Washington all contributed to a dour mood during the second quarter. Money moved out of stocks around the world and back into perceived safe havens like U.S. Treasury securities. By the end of June, interest rates had indeed broken out of their trading range, but instead of heading higher as many had predicted only three short months earlier, the breakout was to new lows in interest rate levels.

Although the stock market has stabilized somewhat since the end of June, interest rates have continued to decline. The 10-year U.S. Treasury is currently yielding a mere 2.5 percent. Except for a few months when we briefly touched this level during the darkest days of late 2008, we have not seen interest rates this low for the last 50 years.

At the moment, investors are caught in the firm grip of fear. Recent economic news is dominated by disappointment on the housing front and a stubbornly high rate of unemployment. Although corporate earnings reports have generally been very positive, there is a high degree of skepticism that the good news will continue. When second quarter GDP figures were revised downward recently from an estimated 2.4 percent to 1.6 percent, investors yawned, in large part because few had believed the 2.4 percent number would prove to be an accurate reflection of what had actually transpired.

Money has been pouring into bond funds and out of stock funds in the belief that earning a paltry 3 percent or so on bonds is a better investment option than buying stocks and risk losing money. We fear that many people are going to find out the hard way that buying bond mutual funds at current levels is not the risk averse move they think it is. When rates begin to rise again, bond returns will become negative very quickly. This may cause investors to sell their mutual fund holdings, causing the underlying fund manager to sell bonds at exactly the wrong time, locking in losses for those unfortunate enough to remain in the funds.

The world seems very uncertain and unpredictable these days and expectations from the financial markets are shifting. Investors are seeking safety and looking for it in different types of investment options than they would have considered as recently as a few years ago. When many blue chip stocks have a dividend yield of 3-4 percent and their quality bond counterparts are yielding somewhat less, is it really time to buy bonds?

We continue to believe that owning a laddered portfolio of high-quality, individual bonds with a portion of your assets makes sense for investors. Owning the individual names allows the bond holder to remain in control of the right time to sell, rather than allowing other owners in a mutual fund to make that decision for you. But we do not believe that it is the right time to make a significant shift in asset mix from stocks to bonds. If you believe in buying low and selling high, stocks currently make more sense than bonds.

So where do interest rates go from here? We are clearly in uncharted waters at the moment. It is difficult to build the case that rates will return to the 3.4-3.9 percent range where they had been trading any time soon. But remember that it was impossible to imagine that rates would be hovering near 2.5 percent when we discussed this topic five months ago. Things can change quickly and it is important to not allow the sentiment of the moment to overshadow well thought through strategic goals and decisions.

Chasing what seems safe in a volatile environment is a dangerous game.

Barbara J. DeMoor, CFA, is CEO and fixed income strategy leader for AMBS Investment Counsel LLC.

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