Immunize investments against rising rates

Fixed-income investors can thank the Federal Reserve and the continuing European financial crisis for the fact that interest rates have remained low, even as the U.S. economy has been growing, though slowly.

In March of last year, it seemed that the days of low rates and high bond prices were over, as rates on the benchmark 10-year Treasury had climbed to 2.3%, from a low of 1.8% in July 2011. Then a new flare-up in the European financial crisis caused a flight to the relative safety of U.S. Treasuries, and the Fed said that it would keep U.S. rates low at least through 2014.

Both developments helped push Treasury rates down again to a new low of 1.43% last July.

Since then, the 10-year Treasury rate has slowly climbed back up to just under 2%.

But bond prices can’t continue defying gravity in the range of 1.4% to just over 2% for too much longer, and financial planners and investment advisers should be taking advantage of the lull to get their clients positioned ahead of the rate increases that seem inevitable.

Investors who have large holdings in intermediate- and long-term fixed-income securities face a loss of capital when — not if — a significant increase in rates occurs, because as rates rise, bond prices fall. The time to take action to protect capital is before that rate increase occurs.

Bond investors have had a great run if they bought before the U.S. financial crisis erupted in the economy, as rates on 10-year Treasuries in April 2007 were over 5%. Even if they bought as late as February 2011, they have had satisfactory capital gains; the 10-year Treasury rate then was 3.64%.

To help the U.S. economy recover from the financial crisis, the Fed has been trying to keep rates low to stimulate the housing market and corporate investment, and to allow the banking industry to repair its capital base.

In pursuit of that goal, it embarked upon a series of programs of quantitative easing. QE1 was announced in November 2008, and rates dropped to 2.13% by mid-December, from 3.97%.

However, despite the Fed’s actions, rates crept up to 3.85% by the end of March 2010.

In anticipation of further Fed easing, and as a result of the burgeoning European sovereign-debt crisis driving investors to the apparent safe haven of U.S. Treasury securities, rates began to decline in April 2010. But despite the Fed’s introduction of QE2, and as the European crisis seemed to ease in late 2010 into early 2011, rates again rose, reaching 3.65% for the 10-year note by January 2011.

A new round of European economic uncertainty and the introduction of Operation Twist drove rates down again to a low last July, from where they have slowly crept up recently.

What this history suggests is that the Fed can’t long keep rates low by its monetary policies alone. With European governments seeming to make some progress in restoring stability to the continent’s weak economies, the time may be near when flights to quality by investors no longer will help the Fed in its fight.

PREPARING CLIENTS

Therefore, financial advisers should be considering for their clients some of the strategies for dealing with rising rates suggested in the special report on bonds beginning on Page 10 of this issue.

Advisers and clients seeking yield have both traditional and innovative investment approaches to generate that yield.

One of the traditional approaches is the use of stocks paying high dividends.

Another is the use of high-yield bonds — low-rated bonds or even those rated below investment-grade, which often are less affected by rising rates.

Among the innovative ap- proaches are bond portfolios that have maximum flexibility in terms of quality of bonds, duration of portfolios, and countries in which they can invest. Another is the development of exchange-traded funds of bonds structured to act like individual bonds in that they mature on a specific date.

Advisers whose clients have a significant percentage of their investments in bond funds should be talking to those clients about ways to immunize those investments against the negative effects of a significant rise in rates by using some of these tools.

Immunization should be undertaken before a disease strikes.