No April fooling, folks, Adam and I really do want more interest rate hikes from the FED. I know (largely because we are frequently questioned) that this sounds strange to many friends and clients, but there are serious reasons why we believe as we do. Since the FED has been a hot topic lately, this seems like a good time to discuss our rationale regarding recent FED actions and inactions.
We know that the FED raised interest rates 3 times over about 16 months, starting in December of 2015. This dramatic improvement has brought interest rates to the elevated level of ---- nearly 1%! Be still my foolish saver’s heart.
Those meager increases alone are not sufficient to justify further rate increases. Other considerations, not in any order of importance or preference, together make a realistic case for higher rates:
- Low interest rates punish savers (many of whom are older people with fixed incomes and and/or limited wealth) by lowering their income derived from CDs and savings accounts. Those who had relied on income from cash-equivalent investments have lately been forced to accept more equity market risk in order to achieve any yield. While recent equity markets have been strong, there remains the ever-present probability of a market correction that could hurt the people who are truly not wanting to be invested, but have no other current alternative. Unwilling equity investors should not have to be squeezed in this manner.
- Low interest rates render economic justification for home buyers, car shoppers, and business investments. But, in many cases, consumers wind up making purchases that financially strain them in the long haul. Expensive cars are also expensive to maintain, and large homes can become “money pits.” Businesses may take on projects that have a lesser chance of success in even a small recession. Too often, financing, whether for a car, a home, or a project, has a future rate adjustment feature. In the event of future rate increases, higher payments and cash squeezes can result.
- Corporate capital structures have been thrown out of balance. In the study of finance, we learn that corporations have two methods of raising capital from investors; they can issue stock (equity) or bonds (debt). Each of these has a cost; after all, investors want a return on their investment in the company. The percentages of equity and debt is called the corporate capital structure.
From the standpoint of the corporation, interest payments are less expensive, as they are tax-deductible. Dividends, however, are paid from after-tax company profits. This makes interest payments preferable over dividends for the corporation, ceteris peribus (all other things being equal). From an investor standpoint, bonds have advantages, in that during a bankruptcy the bondholders are paid before the stockholders (unless government interferes, as happened with GM and Chrysler).
But stockholders have an advantage during normal times, in that stock prices may rise over time if the company succeeds, leading to possible capital gains. Also, dividend payouts often rise over time, whereas bond coupon rates are fixed.
What would a savvy Corporate CEO do? Exactly what they have been doing for years; buy back stock and sell bonds to replace the capital. The capital structure of the company changes, and the earnings per share increase. Less outstanding shares with the slightly lower profits (they had to pay more interest, but at a VERY low rate) means earnings per share that impress the remaining investors.
What’s the problem? Bond prices are not fixed until the day of maturity. During the life of the bond, market prices fluctuate daily according to market interest rates. The relationship between bond prices and interest rates is inverse, one goes up, the other goes down – a “see-saw” effect. When interest rates are closer to the historical norm, investors get higher returns with limited variability, making them good for the income investor we discussed earlier.
However, when rates are rising, bondholders experience lower and lower bond values, rendering their bonds illiquid (remember; liquidity implies there will be no loss of principal). This phenomenon is happening now, but far too slowly, in our opinion. Letting the market work, meaning (in current circumstances) raising interest rates to levels more historically “normal,” may be disruptive in the short term, but we believe that in the longer term, all investors would benefit. Any loss of value in existing bonds would be recouped, and people would be able to readjust their current portfolio risk.
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