S

 April 28, 2004

 

Letís assume that interest rates are at or beyond their low points for this cycle and will be rising measurably in the next two years.  What should you do as an investor or borrower?

There is no one answer for every person.  A financial planner would look at what other investments you have, how long you can hold your positions, whether you are reasonably diversified in case your primary assumption is wrong, and what your life cycle needs are. 

This is why I usually recommend that investors and borrowers periodically get some financial advice. 

However, there are some basic principles that could be followed. 

If you are borrowing for a mortgage or business purposes, try to determine how long you will need to maintain the position if no refinancing surfaces.  Remember, half of all homeowners probably will move in the next five years.

Those 15 year fixed mortgages or 7 year balloons at fixed rates for business (some of the more typical contracts) reflect some of the low short term rates.  However, they also reflect what I have called equilibrium rates for current expectations for much of their history. 

If interest rates rise, short term rates almost certainly will rise faster than long term rates.  Thus, if you really are going to be in your house for 15 years, you probably want to fix those mortgage payments.  On the other hand, if you really think you will move in less than 5 years, an interest only mortgage may be more appropriate at this time.  It certainly will help you to qualify for a bigger house. 

Of course, rising interest rates will slow the attractiveness of houses and possibly of some business assets.  Therefore, house and enterprise appreciation may not be as rapid in the future as in the recent past.  (That is an issue as to whether you should do the action necessitating the borrowing at all.)

Some financial institutions actually match the maturity of assets with liabilities.  Insurance companies are notorious at doing this to minimize their enterprise risk.  Accountants actually allow those entities to declare whether they are holding investments to maturity or will trade them.  If the former, the net worth of the company is not changed when rising interest rates lower the market value of those matched assets. 

Investors may think the same way.  If they hold those bonds to maturity, the market fluctuations because of interest rate changes do not impact the periodic interest payments.  You also will receive the principle at maturity if the entity remains viable. 

However, I am reluctant to consider my investments that way because I do not have offsetting obligations.  As holders of certificates of deposit discovered to their regret, even if your rates are fixed for the life of the CD, the reinvestment of principle can lead to substantially lower interest payments. 

Now we are in the reverse pattern.  Shorten the life of those CDs.  To get yield, you might put some money in three or four year certificates, but begin putting some in one and two year certificates.  When they mature, you might be able to reinvest at higher yields than that four year certificate now promises. 

This appears to be counter-intuitive, because the short yielding certificates offer so much less.  However, you must think of reinvestment opportunities. 

Banks and other bond holders already know that giving up yield to shorten the maturity of an investment portfolio may actually provide higher returns in the long run.  Indeed, one of the reasons that long term rates have increased even before the Fed has done anything is because banks are unloading some of their longer term maturities to reduce the risk of market loss if rates rise.

Mortgage backed securities have special properties, because they pay both because of interest payments and because some of the pool is refinanced.  In a falling rate environment, a bundle of 15 year mortgages may have only a three or four year half life because so many mortgages will be repaid by refinancing. 

When rates rise, the half life shifts to more than five years for the same pool with the same interest rates because refinancing falls.  (Remember, many mortgages are refinanced over time because people move so the half life is unlikely to extend much beyond eight years except in the most extreme interest rate conditions.)

Everything else being equal, the famous economic assumption that almost never holds, I would be dumping mortgage backed securities that I have not purchased recently.  The reason:  investors probably paid for an asset with a shorter expected investment life than now will occur.  But I want to shorten the life of my investments to take advantage of reinvestment opportunities when rates rise.

In my next column, I will address some of the concerns in a rising interest rate environment of stock purchasers. 

 

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