PITTSBURGH -- After a long cycle of historic low interest rates, the pendulum is beginning to swing in the other direction.
Interest rates have been on the rise since the presidential election in November, and last week the Federal Reserve announced another small increase to its key interest rate. Money managers believe this is only the beginning.
"The economy is improving and that's great news," said Paul Brahim, chief executive officer of BPU Investment Management in downtown Pittsburgh. "The Federal Reserve believes it's OK to take away some of the monetary stimulus. In people speak, it means they're going to raise rates."
The federal funds rate, the benchmark overnight lending target, now stands at 0.75 percent to 1 percent after a quarter-point increase that marked the second rate increase in three months but only the third in more than a decade. Fed officials indicated that two more rate increases in 2017 are likely.
A rising rate environment has caused some to question the wisdom of holding bond investments.
There is an inverse relationship between bond prices and bond yields. As interest rates go up, the price of existing bonds fall.
"New bonds pay more interest, making your lower interest bonds less valuable," Brahim said. "We should remember, however, that bonds mature. This means that while the value of a bond may be down temporarily, barring a default, the bonds will mature to face value if held to maturity."
However, Mark Luschini, chief investment strategist at Janney Montgomery Scott in downtown Pittsburgh, points out that investors who own bond mutual funds and bond exchange traded funds are at greater risk when interest rates rise because those have no stated maturity date.
"Therefore, theoretically, if interest rates keep going higher, there's no guarantee the investor will get all of his investment back," said Luschini, who oversees $4 billion in assets.
While rising interest rates could slowly chip away at bond values, losses could be more dramatic in worse-case scenarios.
"Investors should be concerned about the scope and magnitude of potential losses if rates spike," said Paul Jacobs, chief investment officer at Palisades Hudson Financial Group in Fort Lauderdale, Fla. "If markets reverse themselves and bonds rise quickly, people could be shocked at the losses.
"The general consensus is that a 0.5 percent to 0.75 percent increase is what's generally expected," Jacobs said, speaking in terms of percentage-point increases. "That's assuming everything runs smoothly and the economy continues to grow. But if there are surprises or shocks to the system, rates could rise much faster and higher."
Since the November election, the interest rate on the 10-year Treasury bond has jumped from 1.88 percent to 2.5 percent.
Financial adviser P.J. DiNuzzo, president and chief investment officer at DiNuzzo Index Advisors in suburban Pittsburgh, said the bigger reaction to anticipated interest-rate increases has come from short-term bonds.
"The two-year Treasury spiked up in reaction to the Fed statement indicating a potential rise in rates," DiNuzzo said. "The 10-year bond is the national benchmark, and the two-year bond reacted more than the 10-year bond."
The interest rate investors receive on two-year bonds has increased from 1.20 percent to 1.32 percent, while the 10-year bond moved from 2.45 percent to 2.5 percent.
"The 10-year bond already has most of the initial anticipated rate increase built in," DiNuzzo said. "The Fed is weighing the probability that GDP could be higher in the next 12 to 18 months than it has been over the last eight years.
"The more rate increases the Fed can institute over the next 12 to 18 months will give them more leverage in the future to lower interest rates if the economy runs into a soft patch."
Business on 03/21/2017