In normal economic times everyone is trying to predict the direction of interest rates. Economists predict whether interest rates go up or down, when this will occur, and how many basis points they will change. Historically this has been a waste of time, because jut as it has been impossible to predict the stock market movements, it also has been impossible to predict interest rate movements. David Dreman in his book “Contrarian Investment Stratgies; The Next Generation” cites a study done on the results of the 50 largest economic forecasting firms during 1988-1994. These 50 firms tried to predict interest rates throughout the time period. The study showed that not only were they on average wrong, but interest rates moved in the exact opposite direction than they had predicted. Presently circumstances are slightly different. Interest rates are practically at zero and cannot go down further so there are only two questions, when will they move up and by how much.


With interest rates at zero, many people are looking for a low risk way to earn at least a few percentage points. However, currently this is extremely difficult. Short term CDs, money market accounts, and treasuries are all yielding practically zero. If you invest today in Vanguard’s prime money market account which has a yield of 0.12%, it would take over 500 years to double your money! Even ten year treasuries are only yielding 3.33%. This means even to get a 3.33% yield you have to buy a long term treasury. Buying a ten year treasury entails large risk because when interest rates rise, ten year treasuries will likely decrease significantly in value. There were two extraordinary economic periods in the past 15 years. They are; the aftermath of the Sept 11th attacks combined with the recession in the early 2000s, and the current recession. Excluding these two unique time periods, interest rates have been at least 4% for the past 15 years. I think it is fair to assume that when the economy is fully functioning (whenever that will be), interest rates will again reach that 4% level. Therefore, getting a yield of 3.33% when interest rates are almost certain to reach 4% does not seem to be the most intelligent investment.

I think that there are other places in the fixed income world where you can get a satisfactory yield with less risk. You can currently purchase bonds in companies in a strong financial condition, mostly maturing in 6-8 years from now and yielding 5% or more. You can purchase these bonds in companies such as GE, JP Morgan, Goldman Sachs, United Health, and American Express. Many of the companies that have over a 5% yield are financial companies and many people are scared to invest in them. I think this is silly because banks have strengthened their balance sheets lately. Many of the large financial institutions are in far better financial condition than non-financial companies . If you are still scared of the whole financial sector however, you do have an alternative. You can purchase bonds from investment grade maturities with yields between 4-5% that are maturing in less than 7 years in the non-financial sector. There are also many bonds yielding over 5% from non financial companies but many have call features, which many investors like to avoid. Some of these bonds look very attractive when compared to a ten year treasury that yields 3.36%, and a 30 year that yields a mere 4.3% yield. Right now with zero inflation you can get a 5% over inflation yield from some very attractive companies.

Many people avoid longer term bonds right now because they fear that when interest rates rise their bonds will decrease in value. However, this is not necessarily true. First, the Federal Reserve itself has announced the intention to keep inerest rates low for a very long period of time. Second, even if the Federal Reserve started raising interest rates today, it would not increase them immediately to the minimum 4% or more level of normal times, which I had predicted earlier. I looked to historical data to try to get a basic idea of how quickly the Fed takes to raise interest rates when interest rates are very low. The Fed admitted it was too slow to raise interest rates from their level of 1% in 2003-2005. Since the Fed has clearly stated it will be quicker to raise rates this time, I ignored that earlier period. Instead I examined the year 1994. From January 1994 the Fed raised rates from a low 3% to 5% by late December 1994. Therefore it is not unlikely that even if the Fed started raising interest rates today it might take two years to get up to a 4% rate. By that time many of the long term bonds I mentioned previously, will be much closer to maturity. These bonds will therefore be less sensitive to interest rate rises.
There exists another reason why I think that a long term investment grade bond holder has no reason to fear higher interest rates. I looked at some historical data from the Federal Reserve while trying to examine the spread between interest rates and bond yields. I decided to look over data from the past 15 years. The average BPS spread between interest rates and investment grade bonds from 1994 to 2008 was 248 BPS. If you take out the abnormal time periods( highlighted below in red) the spread is 186 BPS. Compare that to today where you are getting a spectacular 512 BPS spread! Therefore even as the Fed raises rates the spread should start to narrow which should provide a margin of safety to bond holders.
Year Interest Rate Moodys Aaa
Bond
Bps Spread
1994 4.21 7.97 376
1995 5.83 7.59 176
1996 5.30 7.37 207
1997 5.46 7.27 181
1998 5.35 6.53 118
1999 4.97 7.05 208
2000 6.24 7.62 138
2001 3.88 7.08 320
2002 1.67 6.49 482
2003 1.13 5.66 453
2004 1.35 5.63 428
2005 3.22 5.23 201
2006 4.97 5.59 62
2007 5.02 5.56 54
2008 1.92 5.63
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