The Federal Reserve’s policy of low short-term interest rates presents potential plusses and minuses for investors.
Consider your exposure to interest rate risk when evaluating your portfolio.
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Excited about two more years of near-zero interest rates? There’s also a flip side.
The Federal Reserve’s recent announcement that it will maintain the federal funds rate in a range between 0.00% and 0.25% through December 2014 has generated the usual analysis about whether Chairman Bernanke and his colleagues are doing the right thing. But the Federal Reserve’s policy may be less about right versus wrong than about the trade-offs for investors and consumers.
When the Federal Reserve makes a determination about movements in interest rates, it bases its decision on prospects for economic growth and whether existing growth can be sustained. The Federal Reserve considers the outlook for inflation, the federal budget, consumer finances, corporate earnings, and a variety of other factors. Maintaining interest rates at a historically low level, which has been the Federal Reserve’s policy since December 2008, is a tool for stimulating economic growth.
A Domino Effect
The fallout from the Federal Reserve’s actions can be significant. The federal funds rate influences the prime rate, which in turn has a bearing on rates that lenders charge for consumer and corporate borrowing. When the prime rate is relatively low, lenders may offer lower rates for mortgages, credit cards, and other forms of credit than they otherwise would. It is important to remember that consumer demand and a household’s creditworthiness are also significant factors in interest rates assessed by lenders.
There are other plusses associated with low short-term rates. Borrowing costs are relatively low for corporations, which can impact earnings and escalate stock market returns.1 In addition, with banks offering marginal returns on savings products, investors have a strong incentive to add to equity allocations with the goal of earning higher returns.
A Flip Side
Just as low short-term interest rates bring certain benefits, there may be drawbacks for investors and also for the broader economy. When short-term rates eventually go up, the situation is likely to be a negative for bondholders because of the inverse relation between interest rates and bond prices.2Historically, rising interest rates have caused the prices of existing bonds to decline because newly issued bonds carry higher rates, which push down the value of previously issued securities. Holding a bond until maturity, when an investor can recoup principal, can lessen interest rate risk.
Low interest rates also are a potential negative for savers, in particular retirees who depend on savings products to finance living expenses. In addition, there remains the question of whether low short-term interest rates encourage certain investors to gravitate to assets that are relatively risky given the investor’s tolerance for volatility and time horizon. A recent blog post noted that flows into high-yield bond funds have exceeded those for ultra-short and U.S. government bond funds.3
Economic policy frequently presents both plusses and minuses, and low short-term interest rates are no exception. You may want to evaluate your exposure to interest rate risk and think about how you will cope with the situation when Federal Reserve policy changes.
1Investing in stocks involves risks, including loss of principal.
2Bonds are subject to market and interest rate risk if sold prior to maturity. Bonds are subject to availability and change in price.
3Source: www.vanguardblog.com, “Why Investors Should Ignore the Fed,” April 19, 2012. Lower-quality debt securities involve greater risk of default or price changes due to changes in the credit quality of the issuer.
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May 2012 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by D3 Financial Counselors, a local member of FPA.