The investor community is fretting over interest rates. Inflation is creeping up and the US Federal Reserve is likely to keep raising rates. When rates creep up, the stock market heads down. And if you hold long term bonds they will continue to pay the current low rate even as new bonds pay more. That means you will either sell them at a loss or hold them with their low yield until maturity. Depending on the positioning of your investment portfolio, will you lose money when interest rates to up?
Short versus Long Term Bonds
We recently wrote about tax free municipal bonds because of the possibility of US infrastructure spending. We noted the risk of getting stuck with a long term bond at a low rate.
Municipal bonds are long term instruments. If you put all of you investment into a bond today and interest rates go up you will be stuck with an interest rate that is less than the current market and that will last for years. An approach that long term bond investors take is to create a bond ladder. They invest a set amount each year in bonds, hold to maturity, and reinvest when the bonds mature.
If you go out today and buy long term bonds you will lose money when the interest rate goes up. Either you will receive less than the prevailing interest rate for years and years or you will sell for a loss in the near term. A bond ladder makes sense today when rates are likely to go up.
The Stock Market
When we wrote about how to protect your retirement savings before the US economy implodes again, one of our concerns was inflation and subsequently higher interest rates.
High interest rates will choke off the US economy even as tax cuts may be providing a temporary boost.
The cost of credit has been at historically low levels ever since the start of the Great Recession even though we are well into the recovery. Long term investors are rotating their portfolios out of growth stocks and into defensive positions as the 10 year Treasury interest rate approaches 3%.
Tax Code Overhaul
But, won’t the tax code overhaul help your investments?
Real estate developers like the family of the president will make out well and perhaps the likes of Apple will get help in the event of a fading product cycle. Important parts of the tax code overhaul are the reduction of the corporate tax rate and the significant reduction of the tax on repatriated corporate profits. Shareholders of companies with billions of dollars stashed offshore may see increased dividends and soaring share prices as corporations take advantage of the new tax code and bring money back home to the USA.
But, the consensus is that beneficial effects of the tax code will be short term for the general economy and over the next few years the effects of an ever-increasing US debt will be felt and will drive the economy down. As the government sells treasuries to cover the US debt, rates will go up and you will lose money in your bond portfolio, many of your stocks, and even your cash reserves as the value of the US dollar continues its downward march.