Investing When Interest Rates Rise

[Roger_R]

I'm in the slow process of revising my traditional brokerage accounts/money market to lower cost and better allocated assets. I have to say that I've had some difficult times making decisions in the current market. For shorter term investments I've parked the limit into I-bonds. At the current rate for I-bonds I figure I can take a hit on cashing in early once the direction of things has settled in a bit more. The remainder of my bond type investments I've split between Vanagard short and intermediate. I'm not so sure that there really is a certain direction for interest rates right now, and maybe indeed this is a good time for these.

Actually the more difficult decisions I've had are with the equity side. It looks to me like current equity returns are not more promising than fixed returns. I'm a little worried about jumping into the fray of things on a down or flat market, when at least I could be keeping up with inflation plus a little. Perhaps a fatal type of apprehension, but there has not been a lot of encourageing news on our economy.

 

[sgeeeee]

. . .Here's how I use my amazing predictive powers:  I simply try to understand my investments well enough to get a good feel for what moves them, what risks are associated with them, and what best/worst-case returns might be.

. . .

Yeah . . . and try to "buy low, sell high" too. All you need to do is write some equations to capture this advice, then apply it regularly.

Sorry, wab. I couldn't resist.

 

[wabmester]

All you need to do is write some equations to capture this advice, then apply it regularly.  

I'm working on it. All I need are a few more teraflops, and I should be able to model every brain on the planet and know what everybody is going to do before they do.

Alright, I don't think we need too many teraflops for the timing move under consideration. You have a choice of a 1-year CD at 3% or an intermediate-term bond fund at 4% (duration of 5 years).

If rates go up 1%, your fund will return -1%. Your CD will return 3%.

If rates stay the same, your fund will return 4%, your CD 3%.

If rates go down 1%, your fund will return 9%, and your CD will still return 3%.

So, if you think all events have an equal probability, then go with the bonds. But if you think rising rates are more likely than falling rates, you might go for the CD and play the game again next year.

This is about as sophisticated as my market timing gets I'm giving up some upside potential, but I've got a pretty good downside, and I only play it this way if I think there is some bias in the probability distribution. Evil Market Timing can be pretty tame stuff.

 

[johnblake]

My time horizon is 54 years. That's how long I'm planning to live off my savings. In my case selling an intermediate bond fund to buy 1 year CD makes no sense. In the long run, the CDs will not keep up. Moving some of the ST bonds and cash over at 3% is a no brainer. But for me, moving 5% of my portfolio around is a major adjustment.

 

[charlie]

Hey ats5g,

Here's how Vanguard's GNMA did vs. their Long Term
Treasury Index in the worst 5 years out of the last
20:

1987...... 2.15% vs -2.93%
1994.......-.95% vs -7.03%
1996 ......5.24% vs -1.25%
1999 ...... .78% vs -8.66%
2003 ...... 2.49% vs 2.69%

All of these were rising interest rate periods in a long
term down trend of rates since the early 80's. Long
rates may or may not have turned the corner. They
could stay sort of flat for awhile.

Unless long rates really spike up, I think GNMA will
do at least as well as a MM fund and maybe as well
as Short Term Corporate. That's where I have bet
my sainted 88 year old Mom's bond money.

I was just suggesting to John_Galt that he consider
GNMA as a place to park his long bond money until the
long rate situation clarifies. I think he would prefer
locking in higher rates after they go up ... if they do.
In the meantime, GNMA is throwing off a pretty generous
yield.


Cheers,

Charlie

 

[ats5g]

Hi Charlie,

We should really be comparing Vanguard's GNMA fund to intermediate term bond funds, not long term bond funds. B/c GNMA's are callable, they act more like int term bonds than LT bonds. Compare GNMA's returns in those down years (1987,1994,1996,1999,2003), you'll see the GNMA fund acting more like an intermediate term bond fund that a ST bond fund. Granted, Vanguard has done a good job of mitigating the negative convexity of GNMA's in their fund, but I wouldn't bet that it won't do as poorly as the other intermediate term bond funds. I'm not saying it will or won't, but I wouldn't be surpised if the GNMA fund lost as much or more than other int term bond funds. I'd treat it as an intermediate term bond fund.

From Vanguard's Plain Talk on Bonds (July 2004)

Mortgage-Backed Securities
The duration of conventional noncallable bonds moves in the opposite direction of interest-rate changes. When interest rates rise, the duration of a conventional bond shortens a bit, mitigating price declines; when rates fall, the bond's duration lengthens somewhat, boosting price increases. By contrast, the duration of mortgage-backed securities - such as "Ginnie Maes," which are issued by the Government National Mortgage Association (GNMA) - moves in the same direction as interest-rate changes. The moves are also more dramatic. In Figure 2, the upper line is the yield of the 10-year U.S. Treasury note, a benchmark for longer-term interest rates. The lower line is the duration of an index of 30-Year GNMA securities. The middle line is the duration of the Lehman Aggregate Bond Index, a measure of the broad bond market. As interest rates rise and fall, the duration of GNMAs can change dramatically even as the duration of the broad bond market remains relatively constant. For example, at the end of March 2004, the average duration of 30-year GNMAs was a little over two years; two months later, it was almost four years. The source of these changes is the activity of homeowners. When interest rates decline, homeowners refinance their mortgage loans, paying off the older, higher-rate loans in the pools underlying mortgage-backed securities and thus shortening the duration of these securities. When interest rates rise, refinancing activity subsides, causing these securities' durations to rise. As compensation for their "duration risk," mortgage-backed securities pay a higher rate of income than other, intermediate-term U.S. government bonds.

- Alec

 

[cute fuzzy bunny]

TH,

Do you have a link to that article?

Thanks,
Alec

I think it was smartmoney because I actually read it on paper (a rarity). The red herring component is I spent an hour in the ultrasound office last week waiting for the wife and read every single magazine they had and there were a lot of them!

 

[cute fuzzy bunny]

As much as I am excited to ER in 6 to 7 months, I am not looking forward to managing of my portfolio since I don't have a few million in the bank to live on.
I have to admire your courage in retiring as early as you did, and to boot, getting married and become a daddy.

MJ

On the first topic, thats good...it'll keep you on your game and paying attention as you wont have a big cushion to ride on.

On the second point, dont confuse being lazy and horny with courage

 

[cute fuzzy bunny]

Well, i know they say past performance doesn't equal future return, but it does beg the question: What the hell else do you have to base the decision on?

Are the horseraces a fair analogy? Which horse does the crowd usually think will win (and because of that, pays worse)? Usually, its the horse and/or jockey that's won in the past.

Actually when I was a kid, my uncle used to take me to horse races. Me and my cousin Phil (we were about 8-10 at the time) decided that the horse that pooped just before racing would be a little lighter than the other horses and stood a good chance at winning. So we gave our two bucks to my uncle to bet on the horse that pooped just before the race. We won. We followed that strategy throughout the evening and did better than my uncle did. In fact I think we turned out two dollars into twenty. He lost most of the bit of money he brought with him. He wasnt happy with us either.

So I guess that rather than looking at past returns information, we should be looking to have cameras installed in our mutual fund companies portfolio managers bathrooms and major companies executive washrooms. "Hey, Eisner just went in with a newspaper! Buy Disney!!!" 8)

I now return you to your regularly scheduled program...

 

[charlie]

OK ats5g, maybe you are right. Let's compare GNMA
to Intermediate Term Treasury Index:

1994........ -.95% vs. -4.33%
1996........ 5.24% vs. 1.92%
1999........ .78% vs. -3.52%
2003........ 2.49% vs 2.37%

I rest my case that comparatively, GNMA has done
better in rising interest rate environments.

The 10 year compound return for GMNA was 6.88%
vs. 7.30% for Intermediate Term Treasury, but the
ride was a little smoother for GNMA.

Cheers,

Charlie

 

[wabmester]

Damn, see what happens when you try to time the market (let this be a lesson to me):

Inflation in Check, Bond Prices Rise Briskly
By JONATHAN FUERBRINGER

Published: September 17, 2004


Bond prices rose sharply yesterday, sending the yield on the Treasury's 10-year note to its lowest level since the beginning of April.

....

 

[brewer12345]

Actually when I was a kid, my uncle used to take me to horse races.  Me and my cousin Phil (we were about 8-10 at the time) decided that the horse that pooped just before racing would be a little lighter than the other horses and stood a good chance at winning.  So we gave our two bucks to my uncle to bet on the horse that pooped just before the race.  We won.  We followed that strategy throughout the evening and did better than my uncle did.  In fact I think we turned out two dollars into twenty.  He lost most of the bit of money he brought with him.  He wasnt happy with us either.

So I guess that rather than looking at past returns information, we should be looking to have cameras installed in our mutual fund companies portfolio managers bathrooms and major companies executive washrooms.  "Hey, Eisner just went in with a newspaper!  Buy Disney!!!" 8)

I now return you to your regularly scheduled program...

You know, it is a lot harder to appear to be hard at work when you are shaking with laughter. Good thing it is a Jewish Holiday and this place is a ghost town.

 

[John Galt]

Hello Charlie. Thanks for the birthday wishes and
give my best to Up-Chuck

Your recommendation is appreciated re. GNMA. My old
pal Bob Brinker seems to be always pushing GNMA
and it may be the only thing I've heard on his show that made sense to me (or maybe he just wore me down?)

Anyway, got a big piece of my "forever" money that is
facing eviction from it's comfortable spot of the last few years (all 7+% and very safe). You are right in that I
would like to see what interest rates will do before
committing this money. I got into "chasing yield" when the bottom fell out of CD rates, but I'm a bit
uncomfortable putting 100% of this into 30 year
maturities just to insure myself 6 or 7% (not knowing
about inflation or a lot of other stuff). So, as I said
before, it (having some money to fuss with) is a nice
problem to have. I will close with this thought. Having
become accustomed to "livin' large" and having come to
an ER mindset late in life, I still have to watch myself
closely to prevent backsliding. Case in point. I want
to buy a boat. Nothing wrong with that. So I tell myself:
What the hell! You are 60 years old. Your wife is gainfully employed. Two (2) years from SS. Fully retired
since 1998 and your net worth has risen steadily.
Take some of that money that won't be earning much anyway and buy a big old boat. You've earned it!"

Now, I am sure I could listen to Satan and just cut loose
and that everything will be fine (or I'll be dead in which case it does not matter) My point is that not having
developed any ingrained frugality before I ERed, I
have to be doubly alert and maybe always will.
Or, maybe I worry too much. Stay tuned

John Galt

 

[Cut-Throat]

Take some of that money that won't be earning much anyway and buy a big old boat. You've earned it!"

You've probably heard the saying. "There are two happy days when you own a boat. The Day you buy it and the day you sell it"

Get a pair of waders. They're cheaper and the exercise will do some good. I also use a float tube that I can throw in the back of my car. Gets to the deeper spots. A lot cheaper than owning a boat. I'm still glad I sold my boat!

 

[cute fuzzy bunny]

You know, it is a lot harder to appear to be hard at work when you are shaking with laughter. Good thing it is a Jewish Holiday and this place is a ghost town.

Glad to be of service, please leave a small gratuity on the tank when you're done.

As far as the appearance of hard work, you just need the right spin on it. Anyone of significance (boss, ceo, etc) asks you why you're laughing at your desk, just tell them "It just occurred to me how fortunate I am to have this terrific job at this great company, I felt giddy and had to express my joy". Then try to look like you mean it.

Just to take this idea a step further, cant you imagine hordes of analysts on tv showing historic and expected future charts of dung volume and frequency, all looking as serious as they do about some of the (ahem) crap they try to measure and predict now?

"The guys at Fidelity have really established a terrific track record since passing out the bran muffins and coffee on an hourly basis! We're anticipating this trend to continue, with each manager producing 30lbs of output by 2023!" :

By the way, just to create some passing semblance of paying attention to the topic at hand, vanguards GNMA fund IS one of the most widely held funds.

On the other hand, Lucent was one of the most widely held stocks in late 1999...

 

[brewer12345]

I'm not all that crazy about GNMAs. Why? You get a higher yield, but in return you get an asset that is pretty funky and hard to analyze. Since these securities pose extension risk in an up-rate scenario, and refi risk in a down rate scenario, you have traded away all of the upside in return for higher yield. No thanks. Thta's one of the reasons I like having a fixed rate mortgage: I get to keep the options and benefit from rate swings.