Last week, I mentioned that just because the Fed wasn’t talking about an exit strategy didn’t mean it wasn’t thinking about one. Sometimes you get lucky—on Saturday, the Wall Street Journal ran with an article on just that.
As the paper reported, Fed decision makers don’t know exactly how they will exit, as it will depend on the circumstances, but they’re now pondering it. To some extent, this puts paid to the notion that we’re doomed to continue on our present path until everything melts down. Yes, the Fed will exit at the appropriate time, even as the economy continues to improve on its own.
The fact that we’re now thinking about it is certainly encouraging, but the exit could create almost as many problems as exist right now, largely stemming from the increase in interest rates that will result as the Fed curbs its bond buying. As interest rates rise, the economy as a whole would take a hit.
The biggest hit, though, would potentially be felt by investors who own bonds. As interest rates rise, bonds are worth less. One measure of risk for bonds is called duration, which indicates the price sensitivity of an asset to interest rate changes. (Wikipedia defines it as “the weighted average of the times until those fixed cash flows are received.”) As interest rates rise, future cash flows are worth less today, and the longer the term of the bond, the more the price will drop as interest rates increase.
Given the stock of debt, both government and corporate, and the proportion of debt in many investors’ portfolios, this matters. Increases in interest rates have the potential to decrease the value of the portfolios for almost everyone.
For the investor in, say, a bond mutual fund, this means that the share price could go down as rates increase, as the underlying holdings are revalued to reflect the new higher rates. There is a good piece on this on FINRA’s website.
Interestingly, if the same investor held individual bonds to maturity (rather than a bond mutual fund), the effect would be more muted. Assuming no default, the bonds would continue to pay the coupon and principal payments as scheduled, and the investor would get par value at maturity. There are drawbacks, of course, to holding individual bonds, but in this case, there would be a benefit. Here at Commonwealth, we have a team that looks exclusively at individual bonds for just this reason.
Such repricing would extend through all asset classes. Stock valuations, for example, are fundamentally the present value of the expected earnings. When interest rates go up, present values decline, so rising interest rates may result in lower stock prices, other things being equal. Offsetting that would be an expectation for faster growth, as the economy improves enough to justify the Fed’s exit, which could grow earnings faster.
Rising interest rates would have a positive effect in terms of reinvestment. If rates go up, any cash flows can be reinvested at higher returns. The key to successfully navigating the exit would be to minimize exposure to capital losses and maximize the opportunity to reinvest at higher rates.
I do not expect rates to increase dramatically in the immediate future, but if the Fed is talking exit—and it is—the time to start the discussion is now.
In addition to duration risk, bonds and bond funds are subject to inflation risk, call risk, default risk and other risk factors. These factors will be discussed in a bond’s offering document or a bond fund’s prospectus.