"We could in the next few meetings take a step down in our pace of purchases." - Ben Bernanke in testimony to Congress, May 22, 2013
With those words, the chairman of the Federal Reserve sent the stock market on a wild ride. Bond holders quickly sold their bonds, which depressed prices and increased rates. In fact, Mr. Bernanke himself was "puzzled" by how quickly rates went up over the past several weeks. Why did these words have such an impact?
The Federal Reserve has a dual mandate: Keep inflation in-check and unemployment low. As you can imagine, the Federal Reserve is constantly monitoring the economic numbers that are reported both by the government and by the private sector. These results over the past several months suggest that the economy is not only on solid ground, but growing again. As everyone knows, rates have been pushed down by the Fed in two main ways: First, the Federal funds rate has been set by the Fed at 0-.25% for an extremely long time. This is the interest rate used by banks and other depository institutions when they lend money to each other. Second, the Fed has implemented an unconventional policy called "quantitative easing," which allows the Fed to purchase long-term treasuries which in turn force the price for those securities up and the yields down. Thus, any of you who have refinanced their mortgage or purchased a home along with a mortgage over the past few years have Mr. Bernanke and the rest of the Fed to thank for those historically low interest rates you locked in.
With more robust economic numbers appearing in the headlines, Mr. Bernanke used the May 22nd appearance before Congress to suggest that they may begin to taper the long-term treasury purchases they were making by the end of the year. We all knew that these low rates could not last forever. It was not a matter of "if" the rates were going to go higher, but "when". Ben Bernanke gave us a hint - the Fed may taper these bond purchases prior to the end of 2013.
As you study your Position Performance report, you will find the your bond funds are some of the hardest hit securities year-to-date. Our intermediate bond funds especially. In most, if not all, of your portfolios the short-term bonds currently make up about 60% of your fixed income. The other 40% is in intermediate bond funds. I have no idea which way interest rates are going to go in the short-term. Some of the big bond gurus believe we are oversold at these levels and they expect rates have hit their 2013 peak. I personally believe that the Fed would not want higher rates interfering with the economic progress they have witnessed and I would guess that they may try to reassure the investing public that they will continue with easy money policies to slow the wave of bond sales and force the longer-term rates back down again. However, everyone knows that rates five to ten years from now will certainly be higher than they are today and, thus, the 6-10% returns we have experienced in our intermediate bond funds over the past several years may dramatically decrease in the years ahead.
It is at this point I would like to remind my readers that there are two reasons we have bonds in our portfolios. The first reason is for the income that is kicked off. The second, and I believe the more important reason, is for the stability they provide when the stock market goes awry. Should the Euro implode or a natural disaster or another geopolitical event occur, we will be very pleased that bonds make up a portion of our portfolio as investors sell perceived risk to buy perceived safety.
We know about the Fed's policy going forward. How about American Investment Advisor's fixed income policy over the next few months? As I mentioned earlier, your intermediate bond exposure - our most volatile fixed income component - is currently running at 40%. Depending upon how the next couple of months go, I may sell that down to 30% or even 20% with the proceeds going into either the money market or CDs. Remember, just like it is important to diversify your stock holdings, the same is true for your fixed income. Thus, we don't want everything in the money market nor do we want everything in intermediate-term bonds.
As for our stock holdings, I believe you will find most of our equity funds are either exceeding or in the ballpark with their respective index so far this year. Some funds were trailing their index pretty badly earlier in the year, but have made up lost ground in the last several weeks.
Over the long haul, higher interest rates will be good for investing purposes. For those who cannot afford to take on the risk of the stock market, higher rates will ultimately allow us to keep a larger portion in the more secure money market or short-term CDs. Remember the days of 5-6% yields from our money markets? The higher yields in the shorter investments would certainly bring comfort to many investors - especially those who are more dependent upon fixed income. In fact, one mutual fund manager suggested that the lower yields are forcing baby boomers to work longer and, thus, the unintended outcome has been a higher than average unemployment rate among 20-somethings.