Retirees should be celebrating higher interest rates.
That’s because retirees have suffered mightily over the last decade from the Federal Reserve’s low-interest rate policy. Most of their portfolios are heavily allocated to fixed-income investments, and they have had to live on the pittance they’ve been earning in interest. They should be able to earn more going forward.
Nevertheless, many retirees are not in a celebratory mood. Their reaction betrays a fundamental misunderstanding about investing in bonds.
The retirees’ gloomy reaction stems from the losses their bond holdings have suffered as interest rates have risen in recent months to their current level—the highest in seven years, as judged by the 10-year Treasury yield TNX, -0.99% Less than two years ago, in July 2016, the 10-year yield was below 1.4%; today it is more than twice as high, above 3.0%.
Many retirees feel that they have no choice but to hold their bonds until maturity in order to make back the paper losses they’re now sitting on.
This is false comfort.
It is true that on the assumption of no default risk, a retiree is assured of getting back 100 cents on the dollar if he holds his bonds until they mature. But there’s nothing magical about this result. You would make just as much money by selling your bonds now, realizing your losses, and investing the proceeds in another bond of similar quality and maturity and holding until the date of your original bond’s maturity.
I owe this insight to Cliff Asness, founder of AQR Capital Management, who says that this misconception about bonds is one of his top 10 pet peeves. He adds:
“The option to hold a bond to maturity and ‘get your money back’… is, apparently, greatly valued by many but is in reality valueless. The day interest rates go up, individual bonds fall in value… By holding the bonds to maturity, you will indeed get your principal back, but in an environment with higher interest rates and inflation, those same nominal dollars will be worth less. The excitement about getting your nominal dollars back eludes me.” (This quotation is from an article Asness wrote for the Financial Analysts Journal in 2014.)
In other words, the paper losses your bond holdings have incurred as rates have risen is water under the bridge. Your focus now should be on the future.
Think about it this way: Interest rates would have had to stay at rock bottom levels in order for the bond portion of your portfolio to maintain the value it had in July 2016, when the 10-year yield was less than half its current level. You can’t expect your bond portfolio to maintain that value and, at the same time, start paying a higher effective interest rate. You can have one or the other, but not both.
To put this in yet other terms: On the one hand your bond portfolio could have a higher net worth and earn very little in interest, or on the other hand you could have a bond portfolio that’s worth less but which earns a greater interest rate. Take your pick.
The retirees who are in a bad mood because of rising interest rates appear to be favoring the first of these two scenarios. But not only would that scenario lock them into a world of perpetually low interest earnings, the second — what we have currently — has a significant ancillary benefit: With higher interest rates, you are able to lock in a greater level of guaranteed income when you shift assets away from equities into fixed income. Up until now, of course, there had been little incentive for retirees to even consider that possibility.
Netting the plusses and the minuses, therefore, retirees should be welcoming the return of higher interest rates.
So don’t worry — be happy!
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.