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
This is why I usually recommend that investors and
borrowers periodically get some financial advice.
However, there are some basic principles that could be
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
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
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.