Making the right decision in a rising interest rate environment
For the last thirty-five years we have watched interest rates gradually drop. In the last ten years we have watched the rates drop to almost zero for money market, savings and short-term CDs.
It has been a long time since you last saw the interest rates posted on a bulletin board or sign at your bank? The rates have been so embarrassingly low no one wants to discuss them.
We have learned nothing on our cash for quite some time now. Many people have taken on more risk and ventured into the stock market. Some have bought into creative returns conjured up with equity index annuities. Others have decided to invest in rental properties or have gone so far as to buy a business to earn a return on their money.
Now we are at the bottom looking up. And we are now at the beginning of a rising interest rate environment. How do we begin to invest in fixed income securities again? The fear is if you buy a long-term bond or CD you will be stuck earning a lower rate of interest while current rates are moving higher. And if rates continue to go up, you may lose the opportunity of making more interest. The other risk is if you stay in cash you will earn nothing by waiting.
How do you make the right decision?
In this environment a bond ladder makes more sense than ever. Some of you may ask what a bond ladder is. A bond ladder is a portfolio of bonds and can also be a portfolio of CDs, fixed annuities or a mixture thereof.
For the purposes of this discussion, we will refer to bonds only.
In a laddered bond portfolio, you own multiple bonds with differing maturities. You can begin with a 6-month maturity which will pay you a lower yield. Then purchase another bond with a 1 year, 18-month, 2 year, 2 ½ year maturity and so on. Each maturity provides a slightly higher yield. If you can envision it, each maturity date is a rung on the ladder. As maturities and rates increase, you are climbing the ladder, thus increasing your overall portfolio yield.
As rates increase, you can take the bond maturing first and reinvest the matured proceeds into a longer-term maturity paying a higher interest rate. As rates continue to rise you are then able to participate in higher yielding bonds as your shorter term lower yielding bonds mature.
You will continually have bonds maturing and you can reinvest at higher yields. Sometimes you may end up with yields the same or lower as interest rates ebb and flow. But if you maintain the course and continue the ladder, you will steadily increase your portfolio’s over all yield.
Food for thought, it has been over thirty years since we have had double-digit inflation and correspondingly double-digit interest rates. If we were to see double digit interest rates again, (I am not holding my breath) the smart money will lock in the high rates long term (and I talking about 30-year maturities) as their bond ladder matures. They will be able to clip high yielding coupons for the rest of their lives and not worry about the long-term risk they may incur elsewhere.
Quite a long shot from where we are today, but there are economic factors out there that could make it happen.
Meanwhile, if you are sitting on a bunch of cash in the bank earning nothing, you may want to consider creating a bond ladder. And once again enjoy earning some interest on the fruits of your labor.
One last note, businesses sitting on substantial sums of cash in the bank, not earning any interest, can create a bond ladder also. They can do so while still having the ability to become liquid if the need arises.
Corey N. Callaway
Investment Advisor Representative