06 Jun The Real Vault

Wealth Preservation When the Rules of the Game Change

In the last decade interest rates have plummeted to nearly zero, first in the US and after that in Europe, where sometimes you must pay the banks to keep your deposits, e.g. negative interest.

In the last 8 years the LIBOR rate has been close to 0%, boosting the economy and the markets; however, in the last few months, and with well-timed publicity, the Fed has been signaling its plans to raise rates.

This could bring about a big change, as rates along the entire yield curve are extremely low, and the market is now accustomed to this near-zero interest rate environment.  The first increase in interest rates could cause those with weak nerves to run for cover.

A close look at the Fed’s comments points to the fact that interest rate increases will be slow, extremely slow. So not only is the risk minimal, but we will have ample time to digest the news.

The significant impact will take place in the bond market. Bond market cycles span multiple years, and the first small step the Fed takes will lead to other small steps on the way to a steeper yield curve.

In wealth management, the bond allocation has long been considered the safe anchor of the portfolio, providing constant yield and not prone to the vicissitudes of the market in the same way that equities are; there is, however, a catch:

When interest rates are declining, it is more than ok to hold fixed rate bond funds. They are liquid, efficient, and the fund manager does all the hard work so all you have to do is sit back and enjoy the ride.

By contrast, in a rising rate environment, fixed rate bond funds are a “danger zone” that we all need to avoid. A rising rate environment means capital losses, which unlike equity losses are here to stay. (interest rate increases are not a straight line, and we will see ups and downs and it will feel like swimming against the current). So, what should we do?

Avoid as much as possible long-term bonds; interest rates may increase very slowly at the short end of the yield curve; however, I will risk predicting that the yield curve will steepen, and long-term rates will increase over time. In fact, this journey has already begun on –  June 6.

Yours,

Michael  Jakoby

Dedicated to my son Mattan, who turned 16 this week, and whose personal vault is already replete with insights.