Originally published January 28, 2014
I believe that we are at the foot of a very long flight of stairs. The top step isn’t in sight and we have no idea how far we have to climb. What we do know is that this stairway can be treacherous to our, in this, financial health. Each step must be taken carefully, always with an eye toward reaching the top safely.
What am I referring to? The possibly impending, long term, multi-decade, rise in interest rates. Think about this, interest rates peaked in 1981 and have been in a long term decline ever since. This means that even a person with thirty three years of investing experience has never invested in a rising interest rate environment.
Ten year charts on bonds? Twenty years on bonds? Thirty year charts on bonds? None of them reflect anything other than a long term interest rate decline. What do we do when interest rates go up for the long term? This may be one of the most important questions investors can ask.
Why should you care? It’s because of the inverse relationship between interest rates and bond prices. When interest rates go up, bond values go down. If an investor isn’t prepared for that, this could significantly impact his or her ability to reach their long term goals, even sabotaging efforts to make one’s money last a lifetime. A bond portfolio that performed well for the last thirty years may perform poorly for the next thirty years.
In the mid-1990s, when we were both working for Smith Barney, I was privileged to meet a legend of Wall Street, Louise Yamada. Louise did some fascinating research on interest rates and found that rates move in multi-decade cycles. In fact, rather than look at ten, twenty or even thirty year charts, Louise thought it made sense to go back to the days of George Washington. George was elected President in 1789, Louise found data going back to 1790. She learned that interest rates move in major cycles, lasting 22 to 37 years. She believes we just finished a downward trend, a thirty-two year cycle, in 2013 and are heading into another major upward trend cycle today. While she found that rates don’t immediately shoot straight up, they do tend to move upwards for many years.
If the trend in interest rates rises for the next twenty or more years, bond holdings, particularly bonds with longer maturities, may likely experience a decline in value.
What to do? I believe that bonds will always serve a necessary and valuable role in many investors’ portfolios, so I’m not suggesting a flight out of fixed income completely. But there are some steps I believe can assist you in guarding against the risk of a potential rise in interest rates.
A first step is to consider a bond portfolio with shorter maturity dates. Bonds with a shorter maturity, in general, will experience less of a decline in value when rates rise. This means that the value of a thirty year bond may decline more than the value of a one year bond when rates rise.
Next, don’t be fooled by short term movements in rates. While I’m saying we’re in for a long term rise, that doesn’t mean that rates are going to go straight up. There will be times, of course, when rates will fall in the short term, but that doesn’t change the pattern we’ve seen of multi-decade trends.
Another step, decide whether it makes sense for you to own individual bonds or to purchase an alternative investment vehicle. Both have merits, it depends on your individual circumstance.
These are just some of the steps we are implementing to shepherd our client’s investment
It’s been said that knowledge is seeing the train coming toward you while standing on the tracks. Wisdom is stepping out of the way.
As always, we at Bourke Wealth Management are working to help our clients make wise financial decisions. Call us if you’d like a second opinion on whether your investment portfolio is positioned to help you work towards your goals.