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Experts see interest rates as a smoldering fuse

A finance prof warns investors who are fond of bonds to be careful.

April 5, 2013
| By Pete Daly |
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The current record-low interest rates are a good thing for home buyers — but not for people who are heavily invested in bonds and need to continuously maximize the return on their investments.

Interest rates on some bonds now “are as low as they’ve ever been. This is a warning to everyone: When interest rates head back up — and they always do — the prices of (existing) bonds will be destroyed,” said Gregg Dimkoff, a finance professor in the GVSU Seidman School of Business. On the faculty there since 1975, Dimkoff is also a certified financial planner.

Dimkoff said the Great Recession and its severe impact on the stock market scared a lot of potential investors and left them “maimed psychologically” with a strong aversion to investing in stocks. So they’ve been putting their money in bonds.

He pointed out that, in the week ending March 27, $6.3 billion flowed into taxable bond mutual funds and exchange traded funds. During the same week, $3 billion went into equities — stocks. In February, according to Dimkoff, $26.7 billion went into stocks; $24 billion into taxable bonds.

The March investments probably reflect a perception that the stock market is starting to slow down, plus other factors such as North Korea threatening to start a nuclear war.

“There is still a huge amount of money going into bonds. One way of looking at that: That’s really dangerous,” said Dimkoff.

“As long as people understand this and are willing to take the risk, that’s fine,” he added. “What’s bad is if they don’t understand it and are blindly going into bonds, thinking they are safer than stocks. They may not be.”

Bonds are still probably the favorite investment of a lot of individuals, according to Dimkoff, especially older people.

Interest rates “could stay down for another year or two, but we don’t know that,” he said. “But when they do go up, they’ll probably go up fairly quickly, and the very longest-term bonds will probably see a loss of perhaps 40 percent.”

If an individual holds a bond until maturity, he or she will earn what they expected when they bought it, but some may regret the missed opportunity to invest that money in something newer that pays a much higher rate of return.

Bonds that haven’t matured can be traded, but if interest rates suddenly jump, it would probably be impossible to sell a bond with a lower interest rate without selling it at a discount — in effect, taking a loss.

When it comes to risk now, “bond mutual funds are really bad,” said Dimkoff, because if interest rates begin going up, the value of existing bonds does down. Some investors in a bond fund will bail out, and the fund will have to sell some of its investments to cover that. The loss will be distributed back on to everyone still in the fund.

“Paper losses are turned into real losses in a mutual fund. So this is probably not a good time to be putting money into a bond mutual fund,” said Dimkoff.

“There are certainly some risks out there,” agrees Alan Kort, a taxable trader in the Fixed Income Strategies team that is part of Fifth Third Bank’s Investment Management Group in Grand Rapids. “We are in an environment we haven’t been in in a long time, with rates being very low.”

The downward trend of interest rates has gone on for the last 30 years, he said, providing a “bullish signal” for the fixed income investment markets. “And now that we’ve approached zero, we really can’t go much lower,” he added.

He called the current Treasury Inflation Protected Securities market “astounding,” with a negative yield on a 10-year TIPS equal, at maturity, to a loss of about 70 basis points.

While he stressed he would not make any investment recommendations, he said fixed income investments are still a very important part of the portfolio management process. In other words: don’t shun diversification in an investment portfolio.

“The prudent thing to do might be to underweight fixed income (investments in a portfolio) or have less exposure there as the prospects become less attractive in this environment. But (fixed income is) still a very important part of the portfolio process,” he said.

“The market is keeping an eye on the (Federal Reserve),” said Kort. “The market is also keeping an eye on the unemployment rate because the Fed said that when a 6.5 percent unemployment rate is reached, that may be the time to start taking action.”

Dimkoff also mentioned the role of the unemployment rate. When asked what it would take to trigger a resurgence in interest rates, he replied: “the economy heating up.”

“The Fed right now is pumping enormous amounts of money into the economy to keep rates down and has been doing that five years now,” said Dimkoff, adding that the Fed has been vague about when that will end.

The unemployment rate for February and into March was pegged at 7.7 percent.

Kort said, however, the Fed is not looking at just the unemployment rate but also the unemployment base, which includes all the people who would work if they could find a job. He added that factoring the unemployment base into the equation would result in an unemployment rate actually closer to 9 percent.

“So there is some feeling that we will need some healing in the job market before we see the Fed start to reduce its accommodative stance,” said Kort.

One last point by Dimkoff was in regard to the national debt. If interest rates begin returning to normal levels, he said, that “will add trillions to the deficit over the next 10 years,” because of all the borrowing the federal government must do.

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