Dear Friends,
Interest rates have gone up again! The Federal Reserve just raised what is called the “fed funds” rate by a quarter of a percentage point, bringing this rate to 2.75 percent.

This is (pick one):

a) Bad news

b) Good news

c) Both of the above

The fed funds rate is the rate that financial institutions such as banks must charge when they borrow money from each other over night. While that sounds a little strange (why would one bank have to borrow money from another bank?) it’s actually quite common.

Banks are required to keep a certain portion of their deposits in “reserve.” This is calculated at the close of every business day. If Bank-A customers withdraw a lot of cash one day, the bank’s reserve might temporarily fall short of its required level. So to meet its reserve requirement, Bank A will borrow money from Bank B (which happens to have excess reserves) in order to show that it has the appropriate amount of reserves at day’s end. When Bank A opens for business the next day, it will transfer that borrowed money back to Bank B.

As you might imagine, there is a cost for this borrowing. However, banks cannot charge each other whatever they want for their overnight loans. They have to use the interest rate set by the Federal Reserve. This is the so-called “fed funds” rate.

The important thing to understand about the fed funds rate is that a lot of other interest rates that affect us as consumers are based on this. This makes sense: when a bank’s cost of doing business increases, like most companies, it passes this along to its customers.

When the fed funds rate goes up, eventually the rates on, say, auto loans and mortgages increase.

On the other hand, banks can also earn more than they did when they could only charge 2.5 percent for an overnight loan. So they usually pass along a piece of this additional profit by raising the interest rate they pay on deposits such as CDs.

The point is, increasing interest rates can benefit you if you’re a borrower, but hurt you if you’re a saver.

Bond investors are also hurt by rising interest rates. That’s because the price of existing bonds — those paying the old, lower rate — become less desirable compared to newer bonds issued at the new, higher rate. As a result, existing bonds drop in value when rates increase.

This isn’t necessarily a problem if you’re the type of investor who holds your bonds until they mature. When they do, you’ll receive the full face value. But if you own bonds through mutual funds — which rarely if ever hold bonds to maturity — or need to sell your bonds before they mature, you will see the value of your investment decline.

What if you want to capture some of the higher income you could get by investing in the newer bonds paying the higher rate of interest? Unless you’ve got a pile of cash sitting around, you have to sell your older bonds. And they’re now worth less than before this latest rate hike.

So, what’s a bond investor to do, especially since Federal Reserve Chairman Alan Greenspan made it pretty clear that this is not the end of rising interest rates? In fact, by the end of this year, economists are predicting the fed funds rate could be anywhere from 3.25 percent to 4.25 percent. In other words, as much as a half percentage point to one-and-a-half percentage points higher than where it stands today.

Let me put this into perspective: less than a year ago (last June) the fed funds rate was at just 1 percent. At this point, the rate has nearly tripled in the past 9 months. If it hit 4 percent by year-end, that would be a 300 percent increase over its low! A rate increase this sharp and swift- even if expected- would be a breath-taking turnaround for bond investors, who aren’t exactly known for liking excitement.

Why has the nation’s central bank been raising interest rates? The main reason is that it kept rates too low (economists would say “artificially” low) for nearly two years. After 9/11 and the Enron/accounting scandals shook consumer and investor confidence, the Fed decided the best way to keep the economy out of a prolonged recession in 2002 was to make money both plentiful and cheap. That encouraged consumer spending, which makes up about 2/3rds of our economy.

The strategy worked.

Last June, the Fed decided the economy was strong enough to withstand interest rates being at their more “normal” level and started to gradually raise them 1/4-percent at a time.After this most recent rate hike, Chairman Greenspan hinted there is now another reason the Fed is likely to continue raising interest rates: inflation has picked up in the short-term. A big factor is higher oil prices.

As indicated above, there is wide disagreement on how high interest rates will eventually go. Mutual fund company T. Rowe Price estimates the fed funds rate will end the year at 4.25 percent and keep climbing. Ted Wiese, who manages the firm’s short term bond fund, says historically the fed funds rate should be about 2-percentage points higher than the rate of inflation, which would put it at 4.5 percent, perhaps a year from now.

On the other hand, Zane Brown, the director of fixed income investments at Lord Abbett funds considers that extreme. He’s looking for the fed funds rate to close the year out at 3.5 percent. “Alan Greenspan is writing his legacy and the last thing he want to do is risk pushing this economy into a slowdown on his way out the door,” says Brown.

Brown points out that “50 percent of all outstanding mortgages were written in the past two years and a significant portion of these have floating rates.” Higher interest rates translate into bigger monthly mortgage payments. “A fed funds rate of 4 percent would crimp the amount of discretionary spending these homeowners have,” according to Brown. That would hurt the economy.

Mario DeRose, fixed income strategist with the firm Edward Jones, says it’s pointless for the average investor to agonize over exactly where interest rates are going. He’s also not overly concerned about inflation roaring back. “The Fed is working to make sure inflation doesn’t increase over the long term and we think they will be successful.”

DeRose predicts short-term interest rates will increase more than long term rates. To prepare for this, Edward Jones is advising income-oriented clients to “ladder” their bond holdings, putting 1/3 into short-term bonds (1-5 year maturities), 1/3 into intermediate bonds (6-15 year maturities), and 1/3 into bonds with maturities in excess of 16 years.

This is a strategy you can also use to a certain extent with CDs.

A laddered portfolio enables you to take advantage of rising interest rates because as your bonds/CDs mature, you can invest the proceeds in newer securities paying the higher rate of interest.

DeRose also recommends moving away from high yield, or so-called “junk” bonds. Strong demand from investors looking for income in this low interest rate environment has driven up the prices of these higher-paying, lower-quality (i.e. higher risk) bonds. As a result, several fixed income experts agree you’re no longer being compensated enough for the additional risk these bonds entail.

How much rising rates will affect you depends on your time horizon, according to Wiese. Under the scenario predicted by T. Rowe Price (fed funds rate eventually at 4.5 percent; 10-year Treasury bond at 5 percent), if you won’t need the money for 4 years or longer, you’ll end up with the same total return (interest income +/- price change) whether you keep your money in a money market account or buy 10-year treasury notes.

“In a rising rate environment,” says Wiese, “four years is the break-even point at which the higher interest rate on the 10-year treasury will compensate for the loss of principal and will equal the return on you’d get if you stayed in cash — about 3.5 percent per year.”

On the other hand, if your time horizon is shorter — say, you’re going to need the money to pay your child’s college tuition in two years — then Wiese recommends diversifying into other types of short term investments that aren’t as sensitive as to rising interest rates as treasury notes. Some suggestions: foreign bonds, mortgage securities, and carefully-selected high yield securities.

Each of these categories brings it own unique risks, but when combined, as they are in the T. Rowe Price Short Term Bond fund Wiese manages, they should cushion the price risk of a short-term fixed income portfolio.

Investors who fall in the upper income tax brackets will do better in municipal bonds than in corporate or treasury securities, according to Lord Abbett’s Brown. A 15 percent decline in the supply of new muni bonds coupled with strong demand means they’re less likely to lose value even if rates continue to rise.

Since you don’t pay any federal income tax on municipal bond interest, munis typically pay lower interest rates than other bonds. But the important thing to keep in mind is how much you end up with on an after-tax basis. If you’re in the 35 percent bracket, “a municipal bond with a 4.6 percent yield is equivalent to getting 7 percent on a taxable bond,” says Brown. “And you’re likely to get better absolute performance.”

To sum this up: rising interest rates shouldn’t automatically make you panic and cash in your bonds. Your time horizon matters. So does your tax bracket. Diversify. Not all bonds react the same way. Laddering (staggering the maturities of your bonds) may make sense if you own individual bonds. If you own bonds through a mutual fund, consider one that owns different types of fixed income investments.

Hope this helps,

Gail

P.S. In terms of our little quiz, any and all of the answers are correct. It depends on your point of view.

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