I probably get this question asked of me more than any other these days, especially by retirees.  Investors were once able to place money into bank certificate of deposits (CDs) or into money market funds and easily earn more interest than the rate of inflation.  Unfortunately, the financial crisis of 2008 changed all that in a major way.  While the events surrounding the dark days of the close of Lehman Brothers, the bailout of AIG, and the nearly $800 billion TARP program, were not the sole cause of this phenomenon, they certainly did not help.  The Federal Reserve (Fed) led by the chairman, Ben Bernanke, had to lower interest rates to avoid the credit and liquidity crisis of that time period.  The Fed brilliantly avoided a meltdown and depression.  The side effect is that financial market participants have gotten used to low interest rates.  You will hear the term “taper” thrown about now.  The Fed is not going to raise interest rates yet; rather, they are going to slow their purchase of Treasury instruments and mortgages on the open market.  They are not raising the Fed Funds rate (do not worry about what that is exactly), but, since they were buying approximately 70% of all US Treasuries issued, bond market investors are worried that this demand/supply imbalance will naturally cause interest rates to rise (interest rates have already gone up).  Well, if interest rates will be higher, shouldn’t that be better for bond investors?

An urgent side note to all investors is as follows:  “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”.  What I mean by this is that the volatility of stocks is far greater than bonds historically.  Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now.  However, your risk tolerance must be taken into account at all times.  While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk.  For example, as most people are aware, the S&P 500 (which represents most of the biggest companies in America) was down over 35% in 2008.  Many of those stocks are included in the push to have individual investors buy dividend payers.  With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon.  If you handle the volatility of the stock market, there is no need to be concerned.  However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield.  Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap.  The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities.  Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment.  While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future.  Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?

The short answer is no to the question posed at the end of the first paragraph.  Before we can answer that question and look at some investment strategies and potential purchases, we need to review how a bond works.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.  All bonds have what is referred to as credit risk.  Credit risk is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser know is interest rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest rate risk relates to the fact that interest rates may rise, while you hold the bonds.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.

How do bonds work in terms of prices?  Most bonds are issued at a price of 100 which is referred to as par.  Corporate bonds and Treasury notes/bonds are usually sold in increments of $1,000, and municipal bonds are sold in increments of $5,000.  The value of a bond is calculated by taking the current price divided by 100 and then multiplied by the number of bonds you own.  Bonds are sold in the primary market (when first sold to retail and institutional investors) such that the coupon (interest rate) is equal to the current interest rate prevailing in the marketplace at that time (sold at par which is 100).  Bonds can be bought and sold after that issue date though.  If interest rates rise or fall after issuance, how does the price of a bond adjust?  If interest rates go up, bond prices will go down.  If interest rates go down, bond prices will go up.  Why?  It is referred to as an inverse relationship.  Think about it this way.  If you own a bond that has a 6% coupon and interest rates rise to 8%, will you be able to see that bond to other investors?  The answer is no if you decide to hold firm to a price of 100.  Why should another bond investor buy a 6% bond when he/she can just buy a bond with very similar characteristics as yours and earn 8%?  The only way that you can sell your bond is to lower the price such that the bond investor will earn 8% over the course of that bond’s life until maturity which is when the company or other entity has to pay the money back in full).  Luckily for you, the process works in reverse as well though.  If interest rates go down to 4%, you have the advantage.  If you hold a bond with a 6% coupon as in the aforementioned example, bond investors will pay more than 100 in order to get that higher interest payment.  How much more?  Bond investors will bid the price up until the bond earns an equivalent of 4% until maturity.  Why is this important to you as an investor today?

Let’s take a quick look at history.  Most financial professionals are not old enough to remember or have been in business long enough to remember the interest rate environment back in the early 1980s.  In the early 1980s, interest rates on bonds were incredibly high compared to today.  The economy was stuck in a rut of higher inflation and low or no growth which was called “stagflation”.  How high were interest rates?  The interest rate on a 3-month Treasury bill was 16.3% back in May 1981, and the prime rate topped out around 20.5% soon after.  For more information on the interest rates of this time period, please refer to this link:  http://www.mbaa.org/ResearchandForecasts/MarketEnvironment/TreasuryYields&BankRates,1980-83.htm. The Federal Reserve chairman back then, Paul Volcker (Fed chairman prior to Alan Greenspan and the same gentleman as the so-called “Volcker rule” of today), instituted a monetary policy based upon the teachings of the famous economist, Milton Friedman, from  the University of Chicago.  Friedman was really the start of monetarism.  Monetarism is simply the effect of the money supply in any economy on interest rates.  In general, as more money in the economy is available, interest rates will go down.  As less money is available, interest rates will go up.  Why?  Think about it in this manner.  If you have to get a loan from a family member and you are the only person asking for a loan, chances are your interest rate will be lower than if that same family member is asked by 15 different individuals.  So the Fed of that time period began buying all types of bonds on the open market.  The hope was that, as the money supply grew, interest rates would fall.  As interest rates fell, it would give more incentive to companies to take out loans to buy equipment and build plants and also to incent consumers to take out mortgages and buy homes or purchase consumer goods with credit cards.  Needless to say, the policy eventually worked.  It started what most refer to as the great bull market in bonds in roughly 1982.

There are only two ways you can make money when you own a normal bond.  First, you earn money from the coupon paid over the life of the bond.  Second, in a falling interest rate environment, you earn money by selling your bonds at a higher price.  Therefore, you can earn money from interest and capital gains.  In a rising interest rate environment, you can only earn money from the coupon.  What individual investors, and some money managers even, fail to realize is this simple fact of finance.  The yield on a 3-month US Treasury bill today is roughly 0.06%.  No, that is not a misprint!  The yield on these bills has gone down over 16% over the past 30 years or so.  The bond market has never seen such an extended period of falling interest rates.  Now interest rates did not fall in a straight line, but the trend has been toward lower interest rates for decades now.  That anomalous occurrence is coming (has come) to an end.  What can individual investors do then?

There are a number of things you can do to deal with the specter of rising interest rates.  I do not recommend any specific securities to purchase.  However, these investment strategies are something to consider.  They are as follows:

1)       Purchase an ETF that invests in floating rate fixed income securities

Investors are accustomed to bonds issued with a fixed coupon.  Yes, that is the most common.  However, there are other bonds that have an interest rate which is variable over the life of that bond.  Why would a company want to consider this?  There are two reasons why.  The first reason is that some companies need to borrow money from financial market participants constantly and for short periods of time.  The second reason is that certain companies that have liabilities which float over time.  Why?  They may have revenues that float over time as well.  It is much more complicated than that, but I do not want to get too bogged down into the details.  The most commonplace is a financial instrument known as commercial paper (CP) which is an example of the first reason.  CP is any financial instrument with a maturity of up to 270 days.  Firms, such as General Electric or Goldman Sachs, will sell CP to institutional investors for purposes of raising working capital.  It might be to pay short-term bills, or it might be to fund operations until money comes from previous sales at a later date.  Whenever CP is issued, the current interest rate prevails.  There are ETFs out there (only a few right now though, such as the iShares Floating Rate Note ETF – Ticker Symbol:  FLOT) that invest in CPs or other variations thereof.  The ETF will hold these fixed income securities with very short maturities.

2)      Purchase a target maturity bond ETF

When you purchase a bond mutual fund, you are pooling your money with other investors.  You do NOT own the bonds that the mutual fund invests in.  The mutual fund firm will calculate the value of their bond holdings each day and divide it by the number of shares outstanding to arrive at the net asset value (NAV) of the mutual fund.  The mutual fund will allow mutual fund investors to buy additional shares at that price or sell shares at that price.  Isn’t that just semantics and really is the same thing?  Absolutely not!  When you own a bond mutual fund, the holdings of the mutual fund are constantly changing.  You will see an SEC yield quoted and a weighted average maturity (WAM) of the bond mutual fund show in years.  If interest rates rise and you need to sell, the NAV of the bond mutual fund will go down.  Since the bond mutual fund needs to earn as much interest for its bond investors as possible, they will constantly take new inflows from investors, interest payments, and principal payments to invest in bonds issued today.  Therefore, the NAV of the bond mutual fund has to go down.  Since you are never holding the actual bonds to maturity, in a rising rate interest environment, you will receive interest payments from the bond mutual fund, but the value of the bonds held by the bond mutual fund will fall gradually, ceteris paribus.

Since interest rates have been falling for so long, most individual investors do not know this.  How do you combat that?  Well, BlackRock and other ETF providers have developed a new type of ETF which is based upon a target maturity.  How do they work?  You can purchase an ETF that might be in existence for five years, for example.  The ETF will invest in bonds with five years to maturity and then disband the ETF after five years.  Thus, as a bond investor, you are only subject to default risk.  As you will recall, default risk is the risk that an entity will not pay back the principal and interest on the bond.

3)      Purchase a floating rate instrument directly with a credit enhancement

There are fixed income securities sold which have interest rates that are set very frequently.  One of these instruments is known as a put bond or floater.  Put bonds or floaters are fixed income securities that are sold with an interest rate that is “reset” (i.e. adjusted to reflect current interest rates) on a periodic basis.  For example, they might be reset daily, weekly, or monthly.  Therefore, if you own a floater and interest rates go up, you will earn that new interest rate.  If interest rates go down, you will earn that interest rate.  You do not lose your original principal.  The interest rate is always chosen such that the floaters will sell at par.  Now owning a floater that is tied directly to a company, non-profit, charter school, municipality or other entity is a risky proposition.  You are subject to the credit risk of that entity, and they might default.  However, you can get around being exposed to the credit risk of that entity.  It is possible to purchase floaters (most are actually issued this way) which have a credit enhancement.  A credit enhancement is something that the obligor (i.e. the entity that issues the bonds and needs the money) purchases.  The types of credit enhancements are not that important; the concept is more significant for individual investors.  A floater with a credit enhancement means that, if the obligor defaults, the entity providing the credit enhancement will pay the principal and interest then.  Banks and bond insurers offer credit enhancements.  Therefore, when you purchase a floater with a credit enhancement, you are essentially exposed to the credit risk of the entity providing the credit enhancement and not the issuer (i.e. obligor).  Yes, you still have credit risk.

With that being said, there are floaters out there which have a credit enhancement from Bank of America, JP Morgan, US Bank, Wells Fargo, or Assured Guaranty.  The interest rate will be lower than the interest rate that the company itself would be able to get by accessing the bond market directly.  However, it will save you the time of trying to do a credit analysis of a small manufacturing firm with $50 million in annual revenues.  You can contact a middle market or larger full service brokerage firm to see if they offer put bonds or floaters for sale.  If they say no, but they offer Auction Rate Securities (ARS), it is not the same thing at all.  ARS have very different characteristics which rear their ugly head during liquidity crises like the financial crisis of 2008.

4)      Purchase mortgage back securities (MBS)

MBS may have a bad name from the financial crisis of 2008.  I am not referring to MBS that invest in subprime loans.  Subprime loans are speculative in nature.  I am talking about mortgages issued to individuals with good credit scores.  You can purchase an MBS issued by GNMA (Ginnie Mae), FNMA (Fannie Mae), or the FHLB (Freddie Mac).  The GNMA is a government sponsored enterprise (GSE), and FNMA and FHLB are sometimes referred to as “quasi” in nature.  These MBS essentially purchase thousands of mortgages that meet certain requirements in terms of size of the loan and credit of the borrower.  The mortgages are pooled together and sold to investors.

These securities are essentially pass through instruments.  Pass through instruments mean that the principal and interest payments flow through to the owners of the MBS.  Why might you want to own these?  In a rising interest rate environment, people with mortgages will not refinance their mortgages.  Why would you get rid of your 4% 30-year fixed rate mortgage and change to a 5% 30-year fixed rate mortgage?  As interest have been falling over the past several decades, it has been advantageous to refinance ones mortgage to a lower rate.  There are bond mutual funds that invest in MBS.  However, they fall subject to the same phenomenon that I mentioned above.  You are investing in a pool and do not own the MBS directly.  If interest rates go up and you need to sell that bond mutual fund, the NAV on the bond mutual fund will go down.  You can inquire at your local brokerage firm about MBS.  Now if your broker or Financial Advisor talks to you about collateralized mortgage obligations (CMOs) being the same thing basically, that is not the case.  CMOs do offer different characteristics which may be attractive, but they are much harder to analyze.

5)      Purchase bank loan ETFs with a floating rate

Most corporations borrow money from banks with a floating interest rate.  The interest rate adjusts at certain points and is calculated as a spread over some benchmark interest rate.  The most common benchmark is LIBOR and specifically 3-month LIBOR since many bonds reset quarterly.  Banks will package these loans together and sell them as syndicated loans to various interested institutional investors.  The advantage of these securities is that the interest rate will move up in a rising interest rate environment.  Additionally, most corporate treasurers will enter into an agreement, called an interest rate swap, to change the corporation’s payments into essentially a fixed interest rate.  The complexity of the interest rate swap is not important to discuss in great detail.  The point is that the corporation will then have a fixed interest payment and knows how much they will have to pay over time.  Thus, there will be no surprises if interest rates spike.  Therefore, you are exposed to the credit risk of the corporation for each bank loan.  Remember though that there is diversification in each of these syndicated bank loans because the ETF’s investment advisor will buy many bank loans to diversify the default risk of any one corporation.  One example of an ETF is offered by PowerShares and is called the PowerShares Senior Loan Portfolio ETF (BKLN).  A number of closed-end mutual funds offer similar products.  However, you should always be aware of the management fee assessed by the advisor overseeing the investments.  The expense ratio for many of these closed-end mutual funds is significantly above 1% which tends to offset the benefit of owning such a security because your investment returns will be lower as a result.

6)      Consider purchasing bonds issued by international firms or different countries

International firms and different countries have bonds that sell at different interest rates.  The nice thing about these bonds is that they are affected by different factors or the economy may be in a different stage than the US.  It is akin to the multiverse concept of Mohammed El-Erian of PIMCO.  El-Erian tells investors that the global economy is not simply something that is changing in one direction or in one way.  Rather, he states that different countries or regions can be moving in the same or opposite directions at any given time.  Furthermore, bonds issued outside of the US provide diversification to your investment portfolio.  It is the concept of not “having all your eggs in one basket”.  It is one other option for you.  There are countries which are in the process of lowering interest rates, so you can benefit from the interest rate payment and capital gains then.

One other thing you can do is to just reduce your duration.  Duration is simply the time it takes for your bonds to mature.  Under normal market conditions, bonds with shorter maturities have lower interest rates than bonds will longer maturities.  Believe it or not, that is not always the case though.  When short-term interest rates are lower than long-term interest rates, bonds with shorter maturities are less sensitive in terms of price movement than longer maturities.  I do not consider this an investment strategy really.  It is just a way of lowering risk.  As previously mentioned, when you hear financial professionals speak about searching for yield in other ways like investing in dividend stocks or MLPs (master limited partnerships), that is not investing in fixed income securities.  Given your risk tolerance, you should have a set allocation to fixed income securities.  You might decide to replace some of that allocation with a higher level of other stocks or other instruments.  However, that is a choice, and you are normally increasing the risk of your portfolio.  I am not saying that is good or bad.  I am simply saying that implementing this strategy comes with tradeoffs.