Higher Interest Rates Benefit Your Clients

Wednesday, October 02, 2013 19:49
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Higher Interest Rates Benefit Your Clients

Advisor, educate thyself! Don't foolishly believe that rising rates are bad for long-term investment goals.

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Private client advisers are at a crossroad. Interest rates have risen steadily and though they moderated some recently, are likely (though not certain) to rise again for awhile -- at least until the Fed has unwound its Treasury bond positions (quantitative hardening?).   
 
Educate your clients to know that although their bonds' prices are falling, this is irrelevant unless they sell the bonds (or bond fund shares) and invest in something else like cash, shorter duration bonds, or anything other than bonds similar or longer in duration to what they have been invested in. Understand that we are talking about long-term portfolios, not money a client needs to spend or have available in the next four to five years. (This time horizon should influence the average duration of your portfolio of bonds). 
 
For your clients' long-term money, you, and they, should be hoping for rates to increase. Yes, in spite of the drop in their bond prices in the short run, they will benefit greatly from increasing yields as rates rise. 
 
I won't cite all the research available on the realities of how individual clients benefit from rising rates and are harmed by falling rates in the long run -- you can do that on your own. What's important here is the basic premise that clients with long-term portfolios should be happy to suffer the shorter term paper losses of falling bond prices, in return for higher yields over the long run. 
 
Unlike a stock, which might not come back for many years, if at all, a bond has a set maturity date at which time it is paid in full. (I'm assuming here we are focusing on investment-grade bonds with very low default risk). 
 
So every year, the "loss" resulting from the interest rise is lessened, until at maturity it is zero. Even if you paid a premium, you still get the original yield you purchased at that time. So nothing is lost here either. And, yes, this concept holds true even for a bond fund! 
 
Though the fund itself does not have a set maturity date, the bonds in it do. And every day the bond gets closer to maturity, the loss is lessened. If a bond is sold before maturity and another bond purchased, remember that the bond purchased is cheaper, too. 
 
Like a homeowner who has to move in a down market -- yes, your house has gone down in value, but so has the home you are buying! What have you lost? Nothing, unless you are downsizing! 
 
Always better to buy up in a down market and down in an up market. Every homeowner knows that; bigger houses go down more than smaller houses! 
 
Bonds work the same way, only "buying up" means increasing the bond's duration, buying down means decreasing it. So instead of going shorter term when rates have risen, just the opposite may be more rational. 
 
Simple enough concept but it is up to you to get clients to understand it. Performance numbers may go down, but the client has lost nothing unless they panic and sell. 
 
Again, this is true even for a bond fund owner. Liquidations made to pay off frightened shareholders effects only the liquidating shareholder's return. The losses generated by the required bond sales will actually be useful for sheltering future gains. 
 
As long as you stay put, you will get the yield you paid for plus the higher rates as interest payments and other cashflows are reinvested.  Clients should be focused on yields first and only, and ignore total return when it comes to bonds.  A focus on total  bond return may be harmful to your client's long term portfolio's health.

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