There’s one question that’s been asked since last year and still hasn’t been answered – when will the Fed raise rates? Nobody has the answer, not even the Fed. Still, we ask the question because when it does happen, it will affect most asset classes.
If you’re living under a rock, interest rates are at all time lows. That’s not a big secret but we’re stuck with this reality…for the moment.
From different angles this is either good or bad news.
It’s a great time for anyone who wants to borrow cheaply. Companies can basically refinance old debt at lower rates to lower their cost or issue new debt at the lowest rates ever to grow the business at a much lower cost then in the past. People can do the same with mortgages and other loans.
However, investors searching for income can’t find it where they usually look. The true income investors want safety and income wrapped together because they actually live off it. The other income investors want it because they read somewhere that assets with a yield are less risky than assets with no yield. In many cases this is true, but not in extreme cases.
When you can’t find the yield you want in the typical places – government bonds, CDs, and money market funds – you look elsewhere. This is what every income investor has done for the past six years – chase yield.
So government bonds were replaced by corporate bonds, which were replaced by high yield (junk) bonds, emerging market bonds, peer-to-peer loans, preferred stocks, REITs, MLPs, royalty trusts, and dividend stocks.
Maybe the income investors did this intentionally. I’ll bet most didn’t. I’ll bet most income investors picked a fund labeled “High Yield” or a fund with a better yield than what they previously got and just accepted that the fund still falls into the “safer than” category.
When you ignore the extreme cases and don’t ask “what if” – what are the risks? what if interest rates rise? what if rates rise sharply? can I handle the outcome? – but instead only invest based on yield, you end up taking more risk then you’re used too because prices move as a counterweight to interest rates. The risk is in your reaction to prices moving in the opposite direction of rates.
In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. – Warren Buffett
At this point we’re used to only seeing rates fall. It’s dragged on longer then I thought it would and it could continue to do so for a while longer. But what happens to your portfolio when it ends? And are you prepared for it?
- Simple Financial Solutions Often Beat the Complex Ones – C. Richards
- What You Can’t Learn From Your Heroes – A Wealth of Common Sense
- The Real Point of Active Investing – ThinkAdvisor
- Star Investors Reveal Their Hits and Misses – WSJ
- You Would Have Never Believed It – M. Housel
- Average Returns, Rarer Than You Think – B. Ritholtz
- 11 Stock Market Rules to Live By – Midnight Trader
- Our Gambling Culture – McKinsey Insights
- Peter Thiel on the Future of Innovation (Video) – Conversations with Tyler
- NYU Stern School of Business Spring Valuation Class (Video) – A. Damodaran
- Scaling Everest – Washington Post