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Written by Adam Stauffer, CFA, Offshore Investment Advisor
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Wednesday, 16 February 2011 |
Rising US Interest Rates Take Their Toll Locally
In the last months of 2010, US Treasury rates—or the interest on US government debt—started to climb from near historic lows.
The combination of a second round of quantitative easing by the Federal Reserve and an extension of former US President George W. Bush-era tax cuts sparked a rally in 10-year Treasury rates from a low of 2.45% in early October to around 3.5% at the time of this writing.
While the prospect of rising rates is welcome news for investors in CDs, many of whom have realised negative real rates of return over the last several years due to near zero percent interest rates, the impact on short-term CDs will be muted. In fact, the benchmark three-month CD rate only increased to 0.29% from 0.27%. Instead, the primary impact will be felt in mortgage rates and more generally across an investor’s portfolio.
Thirty-year fixed mortgage rates, which hit a 40-year low of 4.17% in November, have started to rise and currently stand at around 4.80%.The Mortgage Bankers Association anticipates that rates will rise slightly, hovering around 5% in 2011 and increasing to around 6% in 2012. In the BVI, rates are currently around 6.75% and have been relatively stable compared to the US. While there is no guarantee that rates will continue to rise, there is a lot more room to increase than there is to decrease. As a result, now may be a good time to think about refinancing.
Furthermore, rising Treasury rates will have a significant impact on investors’ portfolios. In a sick twist that only Wall Street could serve up (it’s not actually Wall Street’s fault), just when individual investors flock into the historically safe, calm waters of bonds, may be the time when bonds are not so safe and calm. Bonds, which typically pay a fixed coupon, expose investors to interest rate, or duration, risk. This means that when interest rates rise, the price of the bond falls. For example, a 1% jump in Treasury rates roughly translates to a 5% loss in the price of a 10-year Treasury note. As rates rise off of historic lows, investors may find that the wealth preservation characteristics of some bonds do not live up to expectations.
However, by replacing rate sensitive investments with ones that are more credit sensitive, such as emerging market and high-yield bonds, and ones that have very little duration risk, such-as floating rate loans, investors may be able to safeguard their portfolios against rising rates. Emerging market and high-yield bonds are generally less sensitive to changes in interest rates because their prices are linked more closely to the credit quality of the individual issuer than to the level of interest rates. Meanwhile, floating rate loans, or bank loans, are corporate debt obligations that pay interest that resets with the 1-, 3- or 6-month LIBOR. Simply put, as interest rates rise, so does the interest paid by the bank loan. This reset feature lowers the duration risk and helps act as a hedge against rising rates.
Given that treasury rates have not broken their long-term downtrend, the current rise could just be a short-term correction and rates will eventually head lower again. Regardless, we are starting to see real signs that the economic environment ahead is changing. Now is the time to start planning for what that change means to your finances and portfolio.
Disclosure: The material in this article does not constitute advice and the investments mentioned may not be suitable for all investors. Consult with your financial advisor. Offshore Investment Advisor holds treasuries, emerging and high-yield debt and bank loans in most of our clients’ individual portfolios.
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Last Updated ( Tuesday, 01 March 2011 )
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