Interest Rate Risks

For 80% of consumers, exposure to interest rates have been in mortgages, car loans, and passbook savings, but not stocks and bonds.  For several years, consumers who are investors, and especially retirees, sat on cash to avoid the volatile equities market and low-yield fixed income market, usually CDs or municipal bonds (“munis”).  High grade bond yields have been ultra low, and all yields have been suppressed by a nervous Federal Reserve (Fed).  Investors await the more generous yields such as 5% from 10-year Treasuries available in 2007.   

Some analysts say munis are an underappreciated source for fixed income, generally yielding 1% to 4% per year.  Others are concerned that some municipalities who float these bonds are financially shaky, making the munis a risky investment that deserves a risk premium higher than implicit in the current prices.  That creditworthiness risk is muted by the advance warnings issued by any municipal agency facing financial challenges.  Still, the financial health in many branches of local government would be susceptible to another recession – as may come from Washington shenanigans.

Beyond those, is a pervasive risk facing all financial instruments – “interest rate risk.”  The risk that interest rates might rise is a problem for anyone who wants to sell bonds in a secondary market.  The Federal Reserve bragged that it will keep rates low until unemployment is below 6.5%.   We wonder how quickly it will permit rates to rise, and whether the rising rates will be entirely a voluntary phenomenon.  Some of the sovereign treasury buyers will have a say in rates. 

In the third quarter of 2000, 2003, 2005, and 2007, the 10 year Treasury note yields were 6.5%, 1%, 3.5%, and 5.2%, respectively, for an average of 4.05%.   At yearend 2012, it yielded just 1.72%, a result of equity investor timidity and government interventions.  Those interventions include bailouts (TARP and automotive industry), the “stimulus fund” (alas, the only thing shovel ready was rhetoric), the Fed’s QE1, QE2, “twist” and now QE3.   The federal government keeps spending money that must be borrowed, and politicians are reluctant to stop that vote-getting practice. 

If the Fed cannot hold interest rates down, rates will rise on new debt to levels near the 4% recent average.  That could double all taxpayer’s debt service burden, not just those who trade stocks and bonds, and it would crater the market value of bonds in consumer’s portfolios such as 401(k)s, pension funds, and IRAs.  

Alan Daley is a retired businessman living in Florida and following public policy from a consumer’s perspective.

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