The Risks of Rising Rates

We live in a world of historically low interest rates.

If you don't believe it, here is another relic of the past that I discovered as I was going through a pile of old books and materials in my basement this past weekend.

It is an "Equal Monthly Amortization Payment Book" showing the dollar amount of monthly payments required to amortize a loan at various interest rates. It was published in 1978.

Do you notice anything about the book?

It does not assume that anyone will be interested in the monthly cost of any loan with less than a 7% interest rate on a home mortgage.

How times have changed.

For some perspective, here is a graph of the average 30-year fixed mortgage rates in the United States since 1971. When the book above was published, average mortgage rates were over 10%. The last time they were over 7% was 15 years ago. After a recent spike, they are now at around 4.25%.

Credit: Federal Reserve Bank of St. Louis

Of course, just as things that are up can go down, things that are down can go up.

What are the potential effects of an increase in interest rates?

The low interest rates we have been experiencing are something akin to being on a drug. It makes you feel better but does it really make things better in the long run?

There is no question that the low interest rates have contributed to a general increase in the value of assets such as houses, stocks and bonds. Low interest rates let you buy more for the same amount of monthly payment. Consider these payments on a 30 year mortgage.

At a 4% interest rate, borrowing $300,000 results in a $1,432 per month payment.

At a 8% interest rate, borrowing $300,000 results in a $2,201 per month payment.

To get the monthly payment down to around $1,400 per month at 8% interest, the loan would have to be around $200,000. Since buyers generally can only buy houses based on the monthly mortgage payments their incomes will support, this house is no longer affordable to that buyer.

She will have to find a more affordable home, or more likely, that house will have to come down in price because many more buyers will find themselves in a similar situation. After all, a house (or any other asset) is only worth what someone else is willing and able to pay you for it.

Declining interest rates have been a great tonic for the housing market in recent years. The same is true to the stock market. As a general rule, stocks will rise as interest rates fall and stocks will struggle in the face of rising interest rates.

Of course, we see the greatest correlation between interest rates and values when we look at bond prices. Simply stated. bond yields and bond prices are something like a teeter-totter at the playground.

Credit: Firstshare.com

When interest rates decline, the price of the bond increases. This is the general secular trend we have been in the United States for over the last three decades. In many respects this has been the most favorable period in history to gain wealth from investing. Both stock and bond returns had a tailwind that made it relatively easy to compound wealth. All you had to make sure you did was save some dollars to get the compound returns to work for you.

However, when interest rates rise, the price of the bond declines.

Many people have the mistaken notion that investing in bonds is always "safer" than investing in stocks. That comes from the fact that holding a bond means that someone has promised to pay you an established amount at the end of the bond's term. If you can wait until that time to get your money and the borrower can make good on the promise, it is safer than the uncertain return on a stock where there is no promised return or repayment.

However, what happens in the interim? What if you are a 70 year retiree and are holding a treasury bond that will not mature until you are 100 years old? What if you need to sell the bond when you are 85?

This is where bonds become risky as you could become exposed to the sensitivity the bond has to changes in interest rates. Bond pros refer to this as the "duration" of the bond.

Jared Dillian writes for Mauldin Economics and he recently wrote about the risks to bond investors due to rising interest rates. He did an excellent job in explaining the risks in bond investing and how the concept of "duration" plays into it. Note that he wrote this piece in September when interest rates were near their all-time lows and before the recent upturn in rates.

If you own a bond, you are exposed (positively or negatively) to changes in interest rates. If interest rates go up a percent or two, you want to know what is going to happen to the price of your bond. 

Two things we need to know about duration:

1. Longer-term bonds have more duration
2. Lower-coupon bonds have more duration

There is a thumb rule in bond mathematics: 

If interest rates go up one percent, the price of the bond will decline approximately (duration) percent.

It’s a thumb rule, it’s not exact. So yes, if the duration of a 10-year note is 9, and interest rates rise from 1.6% to 2.6%, the bond will lose approximately 9% of its value.

So rates go up 1% and a bond goes down 9%. Is that risky?

You mean bonds lose value?
Actually, bonds can lose a lot of value. And my guess is that people have been lengthening their duration in order to get a little extra yield. By moving into long-dated bonds, people have massively increased their interest rate risk.

Dillian's guess that a lot people have moved into long-dated bonds in order to increase yield is right on the money. In fact, this graph from Goldman Sachs (that was in The Daily Shot newsletter) shows that the US Bond Market's sensitivity to rising interest rates is the highest on record.

Dillian points out how big the risk is if you are in a 30-year bond and interest rates rise just 1%.

Lots of people are in long-term government bond funds. Okay, so what is the duration of the on-the-run 30-year bond? 

About 21 and change. So if long-term rates rise from 2.4% to 3.4%, the value of the long bond will decline by…

About 21%.

Are bonds risky? You bet.

What happens if interest rates rise by two percent? Certainly not unheard of.

The price of the bond will decline by 35-40%.

My guess is that people don’t know that their government bond funds could decline by 35-40%

 Think about this: if people thought that there was a realistic chance that stocks could go down 35-40%, would they invest in stocks? No. 

Do rising interest rates pose a risk to bondholders? Yes.

To stocks? Yes.

To homeownership? Yes.

It also poses a risk to the federal budget. When you have $20 trillion in debt a small increase in interest rates can amount to billions of additional costs to the federal government.

The risks of rising interest rates are everywhere.

Be aware of the risks when considering your money.