Executive Summary
With the Federal Funds rate as close to "zero" as it can feasibly get, it would seem that interest rates have only one directly to go: up. And given the mathematics of bond investing - as interest rates rise, bond prices fall - many advisors and their clients have decided that the only prudent course is to wait for rates to rise before investing into the bond markets. Yet the truth - as a recent white paper points out - is that there is a cost to waiting, in the form of earning lower returns while waiting for interest rates to rise. Which means to say the least, if you're engaging in a strategy of waiting on bonds for interest rates to rise... you better be right about when and how much they actually do increase!
The inspiration for today's blog post comes from a white paper published by Asset Dedication, a firm that helps advisors to implement laddered bond portfolios, or more generally liability-driven investing strategies (where assured bond payments are matched to the investor's cash flow needs). The white paper itself, entitled "The Cost of Waiting for Interest Rates to Rise" can be viewed here; while Asset Dedication does have some self-interest in the topic (since their business is having investors "not wait" and invest in their bond strategies), it nonetheless presents some interest and compelling points about the 'cost of waiting' issue.
The first notable conclusion from the white paper is that if you're going to wait for rates to rise, it doesn't pay to try to capture yield at the same time. In other words, waiting for rates to rise while you own bonds themselves really doesn't pay, at least given the slope of the yield curve in today's interest rate environment. If you own a shorter duration bond fund, you still end out losing slightly more principal with rising rates than you gain with higher yield, ending out slightly behind (compared to just buying a laddered bond portfolio now). If you stretch for yield and buy a higher return, higher duration fund, you just end out even further behind. (See pages 12-13.)
If you choose instead to wait by just keeping money in cash-equivalents, and buying bonds later, you give up a significant ongoing yield (given the current ultra-low return on cash-equivalents in today's environment) - which you can make up with higher yields in the future, but they have to rise significantly to make it up! By the math in the white paper (see page 14), waiting in cash would require an interest rate increase of approximately 125 basis points just to break even for having waited 2 years. Granted, in today's environment, many advisors fear the possibility of rising inflation and interest rates that could push rates a lot higher than "just" 125 basis points; on the other hand, many advisors stated similar fears 2 years ago, when rates hit bottom in early 2009. Yet here we are, 2 years later, and rates have not substantively moved at all.
As the white paper notes, this impact can be slightly mitigated by using an instrument like a 2-year CD as a place for waiting, as opposed to just cash-equivalents. By using CDs, you can capture a higher yield than cash, while still ensuring that 100% of principal is available at the end of the time period (when you plan to be done waiting and invest into bonds); however, you are still reliant on actually getting higher interest rates in the future, in order for the strategy to work.
The white paper also notes that the actual probability of interest rate increases this significant - on an absolute and relative basis - are fairly rare throughout history. Of course, many advisors would likely counter that in today's environment, given recent events, the likelihood of a significant interest rate increase is higher than a sheer "random draw" from history. Nonetheless, the white paper still makes the point that really significant interest rate increases are less common than many believe, and getting their timing right is difficult. And if the interest rate doesn't actually occur "on time" as anticipated - as it didn't from 2009 to 2011 - the investor just ends out with less money.
In the end, I suspect that many advisors still assign such a high weighting to the possibility and risk of higher interest rates in the near future, that they will still advise clients to wait and see. But the white paper still makes a compelling point that, at the least, if you're waiting, it should probably be in ultra-short term bonds that actually mature at par in a relatively short time period, or to try to grab a little more yield using instruments like CDs. If you're going to wait, though, it generally doesn't pay to wait IN intermediate or longer term bonds, as the loss in rising rate environments hurts more than the higher yield gains.
So what do you think? Are you investing in anticipation of rising interest rates in the foreseeable future? Would any of this impact your strategy about how you invest, while you're waiting?
Michael: Excellent post. This topic rarely gets discussed in the financial news media, so I’m glad you posted it. I would suggest that rather than being fixated on “what is the (nominal) rate of interest” that investors should focus on “real returns” plus focus on the risk that equities could go down due to being over priced. Investors can get decent yields from EM bonds using open end mutual funds. By contrast a bank deposit may have an early withdrawal penalty.