The Surprising Drop in Interest Rates: Good or Bad for Investors?

2013 was not that long ago. While only three short months have passed, what a change of seasons we’ve had in the bond market.

You see, coming into year end, most market strategist were expecting interest rates to rise in 2014. The investment team at Glassman Wealth Services, like others, heard the same reasons: accelerating global economic growth, a strengthening US job market and continued Federal Reserve tapering which reduced the bond purchasing program and the demand for those bonds. Accordingly, most market participants were positioned, or were making plans to avoid the wrath that rising interest rates would inflict upon their bond portfolios.

A Funny Thing Happened on the Way to Higher Rates

Guess what happened to interest rates instead? You guessed it. Rates fell from 3.04% at year end to 2.72% as of March 31st with most of the decline happening in just January alone. Why? Well as I’ve been known to say, “When everyone in the market expects one thing, the opposite often happens.” But the additional reasons are less robust economic growth due to a bitter winter, continued slowing in China, and worse than hoped for job growth in the US.

So how is this surprising drop in interest rates good for bond holders? There are two primary benefits:

1. Increase in core bond prices: From our perspective, the first quarter of 2014 has given investors a gift. With the drop in rates, core bonds increased by 1.8% (Barclays Aggregate Bond index) for the quarter, with many bond funds doing even better. The average high yield junk bond fund increased by 2.6% while the average investment grade corporate bond fund gained 3.2%, as measured by Morningstar.
2. More time to prepare for rising interest rates: Our strategy at GWS has been a balanced approach – we’ve been deliberate about owning core fixed income strategies while complementing them with exposure to higher yielding credit opportunities. Both strategies have done well through April and we’ve used this ‘gift’ to reposition our bond portfolios and reduce our exposure to any potential rise in interest rates.

Check out: Fixed Income Primer: Learning the ABCs of Bonds

Expectations Going Forward

Going forward, we believe that rates will most likely rise, but within a narrow range. Could rates go even lower and perhaps get back to the 2.0% level of just a year ago? That is highly unlikely, but to get there, one of two things would have to happen. There’d either need to be an unanticipated global economic slowdown or some type of exogenous geopolitical event (war, act of terrorism, virus outbreak, etc.).

When Will We See a Safe Attractive Yield?

Finally, most of our clients are asking us, “When will I see a safe yield again”? Unfortunately, I believe it will be farther out into the future than most would like. So for now, we will continue to employ a diligent, balanced approach to fixed income investing, including the use of investment strategies we call ‘The Stuff in Between’. You can learn more about our Stuff in Between strategy by reading The Best Investment Strategies for Baby Boomers Today.

What We’re Watching

Finally, here are a few things I’m watching that might impact the timing and magnitude of interest rate increases. You might want to keep an eye on these as well:

• Inflation – consumer and producer price indexes (CPI) www.bls.gov/cpi/ and www.bls.gov/ppi/
• Job creation and wage inflation – monthly jobs report – www.bls.gov/
• Small business optimism index – www.nfib.com/surveys/small-business-economic-trends/

Interest rates are hard to predict, and if they rise quickly, they can wipe out years’ worth of returns. So with interest rates currently stable, it’s wise to prepare for a rising interest rate environment.