Beware Rising Interest Rates

As of March of 2012, the 10 year U.S. Treasury yielded 2.35%, and pundits said rates could not go lower – they did.  Afraid of the stock market plummet that coincided with the economic downturn, investors have fled to the safety of fixed income investments.  Following the recession of 2008-2009, investors poured over $1 trillion over a few short years into bond funds.  In the meantime, the S&P 500 has more than doubled in value, and those investors have missed out on historical investment gains.  There is a saying that while history may not exactly repeat itself, it definitely rhymes.  I caution against “reaching for yield.”  Longer term bond funds with below average quality will face downward pressure in a rising interest rate environment as new bond issues become more attractive than the older, seasoned bonds held by funds.  During 2013, long term U.S. bonds lost -9.92% as interest rates started to rise.

Launched in 1973,  the Vanguard Long Term Investment Grade Bond Fund is the oldest Vanguard bond fund.  When the Fed started raising short-term interest rates in 1993-1994, the fund plummeted over 17%.

VWESX November 1993 through December 1994 – Yahoo! Finance

The time period from October, 1993 to November, 1994 was one of the most difficult times for bond funds.  Spoiled by the high rates of the 1980’s, investors sought alternatives to low rate bank deposits, CD’s and money markets.  Money poured into bond mutual funds in the months preceding this time period.  When rates started to rise, short-term funds and those funds that invested in lower quality securities lost significant amounts of money.  Fast-forward to today – interest rates have already started to rise, so it is VERY important to review bond mutual fund holdings for duration and average credit quality.  When rates rise, in general, the most volatile bonds are those with the longest maturities, deepest discount prices (such as zero-coupon bonds) and low credit ratings, so these are areas that investors should consider avoiding.  As always, review your overall asset allocation percentages and be sure you have a written plan for your financial goals.

By focusing on short-intermediate term high-quality bond funds and ladders of highly rated individual tax-free municipal bonds, investors can mitigate the downward pricing pressure created by a rising interest rate environment.  Keep your “safe” money safe.

© 2014 Pawleys Investment Advisors, LLC. All rights reserved.

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