Market Expectations for Interest Rate Increases
Q: Should you stay invested in the short term while waiting for interest rates to rise?
A: First, other than very short-term interest rates that are heavily influenced by the Federal Reserve, it’s difficult to predict changes in interest rates. Second, to determine whether a short-term fixed income approach will be superior to an intermediate-term fixed income approach, you need to know that rates will rise and that they will increase by more than what the market already projects. This second point is one of the most fundamentally misunderstood concepts when it comes to fixed income investing. The ability to correctly predict such changes would be enormously valuable, but research continually shows that doing so is virtually impossible.
Market Expectations for Interest Rate Increases
Using current market interest rates, let’s compare two investment strategies covering the next four years:
1. You can buy a four-year bond with an expected return of 1.80 percent per year and hold it until maturity.
2. You can buy a two-year bond with an expected return of 0.80 percent over the next two years, hold it until maturity and then buy another two-year bond and hold it until maturity.
A simple question to ask: When will the first strategy produce higher returns than the second strategy and vice versa? Crunching the numbers reveals that the only way the second approach will come out ahead is if the expected return on the second two-year bond that you purchase is greater than
2.80 percent. So for the second strategy to outperform the first strategy, interest rates on two-year maturity bonds must increase by more than 2 percent.
This simple example shows that knowing interest rates will increase is not sufficient. You also need to know whether they will increase by more than what the market has already accounted for.
Bottom line: Investors can benefit from taking minimal credit risk in their fixed income portfolios and by generally keeping their portfolios fairly short term in maturity. This, however, does not mean investors should keep everything in very short-term fixed income at all times. In environments in which the yield curve is steep, it can make sense to move a portion of your fixed income portfolio out a bit longer in maturity.
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