Interest rate trap

I get many e-mails a day from different financial planners. Some are great, some are less then that. Some repeat what I think, and some do exactly what I think would be crazy. I need to have these to "keep me in check", so that I don't get convinving myself that I know it all. This one I got in my e-mail box today, and thought that this is exactly the way I see the investment industry going. I took out the advertisements for the company, but wanted to keep the body of their insight. If you want to subscripe to this newsletter they are called Invester's Daily Edge, and I like I said, they are generally pretty good. Hope you enjoy. -Brad
Andrew Gordon Reporting: Baltimore, MD. Tuesday November 17, 2009
A False Sense Of Security
I had just called my favorite uncle, Al, in NYC to thank him for inviting me up for Christmas dinner. (His wife, Rosa, has been making this special family meal for the past four decades.)
As usual, Uncle Al brought up the subject of his investments. “Don’t worry,” he said, “I’ve gone much more conservative since last time we talked. The interest I’m getting isn’t much. But my broker says if the market goes down, I’ll be protected from bad losses.”
“That’s great,” I said. I didn’t want to worry my uncle. But as I hung up, I made a note to myself to have a heart-to-heart with him when I see him over the holidays.
His so-called protection from “bad losses” sounds reassuring. But when push comes to shove, it won’t be able to do the job.
25 Years Later...
One of the most dangerous traps in the investment world is about to be sprung on investors. It wasn’t intentionally set. But it’s still going to catch millions of investors by surprise... and not just any ol’ investors...
The ones who are going to be hurt the most are the same ones who are most convinced that they are well-protected.
How do I know this?
I’ve seen it before...
In 1994, the Fed instituted the first of eight rate hikes to control inflation. I watched as all kinds of bond funds dropped 30% or more. Investors kept waiting for the storm to pass and for their bonds to recover. They never did.
The government will put off raising rates as long as possible. How can they not? They know the second they begin, borrowing (to fund the purchase of new homes and start or expand small businesses) will go down. Spending will go down. And the markets, too, will drop.
And whatever progress the economy had been making up to that point will stop.
It’s already November. The government won’t raise rates this year. It’ll probably happen in 2010, though.
And even if the government puts it off a little longer, the fear of rates going higher will fester.
Perception is reality. Beginning next year, that fear will dominate the market until, well, the government actually does the dirty deed.
In other words, next year is the perfect set up for a repeat per­formance of 1994 and what followed.
A Horrible Investment Trap
As I said, the trap has already been set. The culprit? Today’s low interest rates. IDE’s Steve McDonald explains:
"The Wall Street Journal recently reported that 78% of money market rates are below 0.3%. Problem is, no one can live on that.
"So hundreds of billions of dollars are pouring out of money markets into higher-risk investments like junk bonds and certain bond funds – in search of returns that people can actually live on.
"As interest rates move up the trap is sprung. These higher-yielding bonds drop in value and shaken investors begin dumping their junk bonds and bond funds to try and limit their losses.
“But it’s too late...
"All it does is drive down these bond funds more quickly."


The Hidden Risks of Investment-Grade Bond Funds
Aptly named “junk” bonds are high risk.
But Steve says that investment-grade bond funds also carry risks... risks that the average investor is completely unaware of. The two big problems...
Investment-grade bond funds use leverage. They borrow money against the bonds they hold to buy more bonds. It’s like taking out a second mortgage on your home to buy another house. The extra bonds paid for with borrowed money add to the interest you get.
But when interest rates go up, the interest payment on the loan the fund took to pay you the higher interest rate also goes up. At the same time, the value of the bonds the fund holds drop. It’s a double whammy.
Bond funds generally buy bonds with very long maturities – because the longer the maturity date, the higher the interest paid. But the longer the maturity, the more the value of the bond drops when interest rates go up. So bond funds get killed when rates go higher.
What can we learn from this?
First lesson is that bond funds require just as much scrutiny as stocks and stock funds...
Second lesson is that bonds hate rising rates.

Andrew Gordon

Investor's Daily Edge

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