Tag: Federal Reserve

Bond Math

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As rates rise, investors struggle to understand why bond prices are falling, especially after last year’s rout in the bond market. Bonds are supposed to be stable and boring, not a volatile asset class, yet, they are complicated instruments, providing something for all investors.

The Federal Reserve raised interest rates from 0% to 4.5% last year, a significant increase and the steepest rise in history. As a result, the rate increase destroyed bonds, causing damage to numerous portfolios.

Bonds are fixed-income investments, meaning the coupon does not move, but the other yields can gyrate significantly. A bond is a contract with terms outlined in the prospectus, a legal document. Let’s explore some bond pricing to help you make better investment decisions.

Terms and Data

Coupon: The coupon is the fixed rate on your bond.

Current Yield: The current yield is a function of your coupon rate and today’s price.

Yield To Maturity: The yield to maturity rate is what you’ll earn on your bond at maturity, based on the coupon rate and the price of your bond.

Stable Rates

If interest rates are stable, flat, or not moving, then the coupon, current yield, and yield-to-maturity are equal. For example, if a bond trades at $100 with a 4% coupon, the current yield and yield to maturity are also 4%. You will earn $4,000 annually if you own a $100,000 bond.

Falling Rates

If interest rates are falling, your bond’s price rises like a see-saw in the park. For example, if the coupon is 4% and the price of your bond increases to $110, then the current yield is 3.64%, and the yield to maturity is 2.84%. When rates fall, the coupon is higher than the current yield, which is higher than the maturity yield. You will earn $4,000 annually if you own a $100,000 bond, regardless of the current yield or price.

Rising Rates

If interest rates are rising, then the price of your bond is falling. For example, if your bond has a 4% coupon and the price drops to $90, the current yield is 4.44%, and the yield to maturity is 5.3%. When rates rise, the coupon is lower than the current yield, which is lower than the yield to maturity. You will earn $4,000 annually if you own a $100,000 bond, regardless of the current yield or price.

One Percent Decrease

If you own a ten-year bond, then a one percent decrease in interest rates will increase the price of your bond by 8.5 percent, rising from $100 to $108.50.

One Percent Increase

If you own a ten-year bond, then a one percent increase in interest rates will decrease the price of your bond by 7.7 percent, falling from $100 to $92.30.

Bond Funds

What about bond funds since they don’t have a fixed interest rate or maturity? Vanguard’s Intermediate-Term Bond fund owns 2,144 individual bonds with an average duration of 6.29 years. The yield to maturity is a function of the portfolio’s average coupon, duration, and the prices of their bonds.

Bonds can be simple and complicated. A US T-Bill is simple, but a junk bond issued by a cryptocurrency company is complex. Pay attention to the rating and yield to maturity if you buy individual bonds. If you don’t want to sift through thousands of bonds, purchase a bond fund.

Bye, bye, and buy bonds.

When I was a kid I got no respect. I had no friends. I remember the see-saw. I had to keep running from one end to the other. ~ Rodney Dangerfield.

Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on your asset level.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.

It’s An Emergency!

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Dave Ramsey takes a lot of heat from financial professionals, but his seven steps have helped millions of people pursue a better life. I don’t agree with his entire philosophy, but establishing an emergency fund,  paying off debt, and saving for retirement are tenants that make sound financial sense.

During challenging times, an emergency fund is paramount. I recently bought a new refrigerator, and my Jeep needs an engine repair. Thankfully, I have an emergency fund to cover the costs. If I didn’t have the fund, I would have charged the expenses to my credit card, and a credit card is not an emergency fund!

Stocks and bonds are down sharply. The S&P 500 has dropped 21%, while long-term bonds have fallen 26%. It’s difficult for investors as all major asset classes are in negative territory, and cash is the best-performing asset. If cash is your best investment, you know it’s a tough year! However, a significant cash balance allows your stocks and bonds to recover, and that’s why an emergency fund is necessary if you want to be a successful investor.

What is an emergency fund? Well, it’s a fund you can tap in an emergency, so you’re not forced to sell stocks or bonds when they’re down. The fund is a liquid resource you can tap at any time without losing money. Your emergency fund should own cash, money market funds, CDs, or T-Bills. A silver lining to rising interest rates is you can buy short-term investments with competitive yields. The 1-Year Treasury rate currently yields 3.15%; two years ago, it was 0.14%, an increase of 2,150%!

Here are a few suggestions for establishing your emergency fund.

  • Invest in short-term instruments like cash, money market funds, CDs, and US T-Bills.
  • Your emergency fund should cover nine to twelve months of expenses in the current environment. For example, if you spend $10,000 monthly, your fund value range would be $90,000 to $120,000.
  • Ladder your emergency fund with CDs or T-Bills maturing monthly: one month, two months, three months, etc. The short-term maturities provide liquidity when you need it most.
  • Automate your savings so you don’t have to think about investing monthly.
  • Don’t use Bitcoin, stable coins, credit cards, or a line of credit as a substitute because they can lose value or get terminated by your bank. During previous recessions, banks curtailed credit, and it wasn’t easy to get a loan.

Markets always recover as they did in 2020, 2018, 2016, 2008, 2000, etc., and an emergency fund allows your stocks and bonds to rebound. Cash is valuable, especially when the economy and markets are imploding.

An emergency fund turns a crisis into an inconvenience. ~ Dave Ramsey

June 15, 2022

Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management, located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.

Buy Bonds?

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Buying bonds is the ultimate contrarian play because everyone knows interest rates are rising, and when rates rise, bond prices fall. The yield on the 1-Year US Treasury increased 1,528% over the past year, while the yield on the 10-Year US Treasury “only” jumped 64%. All rates along the yield curve have increased substantially, and they will probably continue to rise.  

In 1990, long-term interest rates reached 9%, and I could not give bonds away since investors were convinced rates were going higher because, in the 1980s, they touched 15%. However, rates declined from 1990 to 2020, falling to a low of  .62% – a drop of 93%. The ultimate bull market in bonds occurred from 1982 to 2020.

A 30-year bond will fall 19% if interest rates rise from 2% to 3% – not a compelling argument to buy bonds. And the higher rates go, the lower prices will fall. We sold most of our long-term bond holdings in March 2020 as yields pushed below 1%, and we shortened our maturities to about two to three years and realized gains while transitioning to a defensive position. As interest rates rise, we will extend the maturities of our bond holdings to capture higher yields.

If rates rise, is there a bond strategy that makes sense? I believe there is, and it’s called a bond ladder. A bond ladder works in a rising or falling interest rate environment, and as rates rise, a bond ladder allows you to generate more income.

Here is how it works. You purchase a three-year bond ladder with bonds maturing in one, two, and three years and they pay 1%, 2%, and 3%, respectively.

  • Bond 2023 pays 1%
  • Bond 2024 pays 2%
  • Bond 2025 pays 3%
  • Average yield = 2%

When the 2023 bond matures, the remaining bonds are now one-year closer to maturity. You now purchase a new three-year bond maturing in 2026, paying 3% with the proceeds from the 2023 bond. Your new ladder now looks like this:

  • Bond 2024 pays 2%
  • Bond 2025 pays 3%
  • Bond 2026 pays 3%
  • Average yield = 2.6%

Your income increased from 2% to 2.6% or 30%.

When the 2024 bond matures, the remaining bonds are now one-year closer to maturity. With the proceeds from the 2024 bond, you buy a 2027 bond, paying 3%. Your new ladder now looks like this:

  • Bond 2025 = 3%
  • Bond 2026 = 3%
  • Bond 2027 = 3%
  • Average yield = 3%

Your income increased by 15%.

Your bond ladder can consist of any maturity from one to thirty years, depending on your appetite for risk. Eventually, your ladder will contain higher-yielding long-term bonds with monthly, quarterly, or annual liquidity.

A physical ladder will take you higher with each rung you climb, and a bond ladder can produce higher income as you purchase new bonds. In addition to higher yields, buying bonds can protect your principal if stocks fall, especially if you own short-term bonds. For example, the NASDAQ is down 9.3% this year, while short-term Treasuries are only down 1.57%.

If interest rates continue to rise, you will have the opportunity to buy bonds at a discount, increasing your total return. For example, if you buy a 10-year bond with a 2% coupon at $100, your current income and yield-to-maturity will be 2%. If rates rise by 2%, the price could fall to $84. If you purchase the bond at $84, your current yield jumps to 2.4%, and the yield-to-maturity increases to 3.9%. It pays to buy bonds at a discount. One person’s trash is another person’s treasure.

What is the top for inflation and interest rates? I don’t have a clue, nor does the Federal Reserve. No one can predict where inflation or interest rates are going. If interest rates continue to rise, consider adding bonds to your portfolio so you can generate more income.

As I mentioned, buying bonds is the ultimate contrarian play because everyone knows interest rates are going higher, but what if everyone is wrong? What if rates don’t rise? What if inflation falls? If you buy when others are selling, you could make money with your shrewd investing skills. Who knows?

Bye, bye and buy bonds.

Bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance. ~ Benjamin Graham

February 11, 2022

Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management, located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.

Rates are rising! Buy bonds?

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The Federal Reserve might raise interest rates next year. They last hiked interest rates in 2018, raising the fed funds rate four times from 1.50% to 2.50%. The relationship between bond prices and interest rates is like a see-saw in a park; when one side rises, the other side falls. If interest rates are rising, why would you buy bonds?  A rate rise will indeed disrupt prices. However, disruption is where bond buyers can find opportunities.

The 30-Year US Treasury Bond yields 2.09%. If interest rates rise one percent, the price will fall 19.4% from $100 to $80.62. If you purchase the bond at $80.62, you have an opportunity to earn 24% when it matures to $100. In addition, the current yield improves to 2.6%. Since 1926, long-term government bonds have produced an average annual return of 5.8%.[1]

Bond and bond funds are considered lousy investments when interest rates rise. However, investors assume, incorrectly, that fund managers do nothing while rates are rising. When rates rise, fund managers buy bonds at lower prices while locking in higher rates. Eventually, lower bond prices and higher coupons will benefit shareholders.

The Franklin U.S. Government Securities Fund (FKUSX) originated in May 1970, and since its inception, it has delivered an average annual total return of 5.85%. Its best year was 1982, returning 33.04%, and its worst year was 1980, losing 12.87%. A $100,000 investment in May 1970 is now worth $1,827,300.[2]

When rates rise, the first reaction for bondholders is to sell. When they sell, it creates buying opportunities for investors with a long-term time horizon. You can take advantage of panic sellers by purchasing bonds at favorable prices. Their pain will be your gain.

Why buy bonds when interest rates climb? 

  • Lower prices
  • Higher yields
  • Better total return
  • More bond investment choices

Don’t fear a rate rise. It will treat you well in the long run.

“The Chinese use two brush strokes to write the word ‘crisis.’ One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger–but recognize the opportunity.” ~ John F. Kennedy.

October 23, 2021

Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.

[1] Dimensional Fund Matrix Book 2021.

[2] YCharts

Fear the Fed?

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The market dropped last week because the Federal Reserve hinted they may raise interest rates in 2023, two years from now.  The Dow Jones fell about 3% as the topic of rising interest rates covered the airwaves.  The Federal Reserve also published their dot plot chart, a chart of where their members expect interest rates to be over the next few years, and several members expect rates to rise above 1.5%. Should we be concerned?

In 1994 and 1995, the Federal Reserve raised interest rates seven times, from a low of 3.25% to a high of 6%. From February 4, 1994, to February 1, 1995, interest rates jumped 85%.[1] What happened to the stock market? In 1994 the S&P 500 rose a paltry 1.3%, but it did not fall. However, in 1995 the index soared 37.6%.

From 1999 to 2000, the Federal Reserve hiked interest rates six times from 5% to 6.50%. The S&P 500 rose 21% in 1999, but it dropped 9.1% in 2000.

From 2004 to 2006, the Federal Reserve boosted interest rates seventeen times! On June 30, 2004, the Fed Funds Rate sat at 1.25%, and on June 29, 2006, it swelled to 5.25%, an increase of 320%. Despite several rate spikes, the S&P 500 rose 10.9% in 2004, 4.9% in 2005, and 15.8% in 2006.

From 2015 to 2018, the Federal Reserve increased interest rates nine times, climbing from .25% to 2.50% or 900%. The S&P 500 rose 1.4% in 2015, 12% in 2016, 21.8% in 2017, and it dropped 4.4% in 2018.

Rising interest rates are a sign of a robust economy and, potentially, higher inflation. Rising interest rates and higher inflation spells trouble for stocks. If rates rise high enough, investors will sell stocks to buy bonds or park their cash in a money market fund. For example, some investors would prefer to earn a safe 5% from a bond rather than risk their capital in the stock market.

Lately, though, long-term interest rates are falling. The Federal Reserve can only regulate the Fed Funds Rate, whereas the market (investors) control everything else, including longer-dated bonds. For the past three months, yields on the US 10-Year Treasury Note and the US 30-Year Treasury Bond are each down more than 15%. If investors are nervous about rising interest rates or inflation, the bond market is telling us otherwise.

Wayne Gretzky once said he’s successful because he skates to where the puck is going, not to where it has been. He is the rare athlete who sees plays develop before others. But Mr. Gretzky is not on the Federal Reserve Board, and predicting the direction of interest rates is hard; trying to identify the actual rate is impossible.

Jamie Dimon, the CEO of JP Morgan Chase, said in 2019, “We’ve actually been effectively stockpiling more and more cash, waiting for opportunities to invest at higher rates,” Dimon said during a virtual conference held by Morgan Stanley. “So our balance sheet is positioned (to) benefit from rising rates.” At the time of the quote, his firm was sitting on $500 billion in cash, waiting for interest rates to rise.[2] What happened? The CBOE Interest Rate Composite Index fell 98.57% over the next two years! If Mr. Dimon can’t predict the direction of interest rates, who else can?

The effective Federal Funds Rate is currently .06%. The 67-year average has been 4.74%, so who cares if it rises a percent or two? I don’t.

When the market falls again because of rising interest rates, use it as an opportunity to buy great companies at discounted prices. Since February 4, 1994, the S&P 500 is up 797%, or 8.34% per year, despite several corrections. A $10,000 investment grew to $89,740!

Rather than waiting for the Federal Reserve to hike interest rates in two years, diversify your portfolio, follow your plan, save your money, and invest often.

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” ~ Henry Ford

June 21, 2021

Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.

[1] https://www.federalreserve.gov/monetarypolicy/openmarket_archive.htm

[2] https://www.reuters.com/business/finance/jpmorgan-stockpiling-cash-waiting-interest-rates-rise-ceo-2021-06-14/, Jeenah Moon, April 9, 2019

Fear Rising Rates?

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Investors fear rising interest rates. Since the start of the year, the 10-Year US Treasury yield is up 66% to 1.54%. It’s still low, but the speed at which it climbed is worrying investors. For the past fourteen years, the yield on the 10-Year averaged 2.33%. The high was 4.01%, the low was .52%. Does it make sense to sell stocks as rates are climbing? Maybe.

Let’s look at rate spikes during this cycle. Despite several rate spurts, the S&P is up 373% since 2008. If you bought stocks during the previous rate spikes, you’re probably sitting on nice gains today. Though we have experienced volatility in the bond market, the trend for interest rates over the years has been down.

  • The yield soared 67% from December 2008 to June 2009.
  • The yield jumped 50% from October 2010 to February 2011.
  • The yield climbed 49% from May 2013 to September 2013.
  • The yield rose 68% from July 2016 to January 2017.
  • The yield increased 54% from August 2017 to November 2018.

During the above rate spikes, stocks rose with an average gain of 11% – counter to what typically happens when rates rise.

Stocks are sensitive to interest rates. When they rise, stocks fall, and vice versa. It’s been this way for centuries. Rates threaten stocks when elevated because investors can buy bonds to realize a safe and sometimes guaranteed return. When will rates be a menace for stocks? I believe the rate threshold is 5%. A 5% guaranteed return for many will be difficult to pass up, and investors will sell stocks to buy bonds.

Additional buyers for our bonds are wealthy foreign investors and foreign governments since our rates are high relative to other countries. Here’s a look at global 10-year government bonds.[1]

  • Germany = -.274%
  • UK = .755%
  • Japan = .0122%
  • Australia = 1.786%
  • China = 3.27%
  • France = -.036%
  • Italy = .75%
  • Spain = .406%

Our rates are in line with Australia’s, but lower than China’s. However, foreign governments and wealthy investors likely will choose our market because of our safety and liquidity. As our rates climb, the money will flow into our bond market, keeping a lid on rising rates.

Rising rates may benefit your portfolio, especially if you carry a large cash balance. As rates rise, so will the yield on your money market or savings accounts. Another way to benefit is through a bond ladder. Buying bonds with different maturities can preserve your liquidity while capturing higher yields. Also, if interest rates are rising, it means our economy is doing well. And, a strong economy will benefit many.

If stocks fall because our rates are rising, I recommend buying the dip as a correction may be short-lived.

Don’t fear rising rates – for now!

Everything you want is on the other side of fear. ~ Jack Canfield

March 8, 2021

Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.

[1] https://www.barrons.com/market-data/bonds?mod=md_subnav, website accessed March 8, 2021

Bye, Bye and Buy Bonds?

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Interest rates are trading near historical lows, but they’re rising. Since July, the yield on the 30-Year US Treasury has soared 42%. Last March, it dropped to a low of .99%. Now it’s yielding 1.88%, an increase of 90%. Rising rates from all-time lows is not a rousing endorsement to buy bonds.

Despite the low rates, bonds belong in a diversified portfolio. Bonds are safe and consistent, and they offer stability not found in other investments like stocks, gold, or Bitcoin. Also, bonds are negatively correlated to stocks, so when stocks fall, bonds rise. During the market correction last March, interest rates dropped 36% as investors purchased US government bonds. As rates fell, the iShares 20+ Treasury Bond ETF rose 15%, while the S&P 500 dropped 12%.

Bonds are a source of funds. When stocks fall, bonds rise. You can use your bonds to buy stocks – buy low and sell high.

Another reason to buy bonds is to match the maturity with your purchase. If you’re buying a new home in two years, then buy bonds with the same maturity – two years.

My career launched more than thirty years ago in Pasadena, California, as a stock-broker hired by Dean Witter. I was young, with no connections, so my primary tool for prospecting was the telephone. I cold-called morning, noon, and night looking for new clients. One of the investments I used for calling was the 30-Year US Treasury bond. At the time, they were paying more than 8%, guaranteed. My pitch was simple: “Hello, Mrs. Jones, this is Bill Parrott from Dean Witter in Pasadena. We are currently offering a guaranteed investment paying more than 8%. Would you like to hear more about it?” I couldn’t give them away because most people thought interest rates were going to rise.  Well, they were wrong, and interest rates dropped more than 87% over the next three decades. If they bought the bonds, they could have enjoyed thirty years of 8% guaranteed income, and their bond would be worth $143 today, a gain of 43%.

Since interest rates are rising, bond prices are falling. The price of a 30-year bond will fall 22.4% if interest rates rise 1%, so my recommendation is to keep your maturities short – less than five years.

Bye, bye, and buy bonds!

January 12, 2021

Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.

Data Sources: YCharts

What’s a Yield Curve?

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The hot topic this week is the yield curve, or more importantly, the inverted yield curve. What the heck is a yield curve?  It’s a collection of interest rates, or yields, plotted on a chart. Rates begin with the one-month U.S. Treasury Bill and end at the 30-year U.S. Treasury Bond. The curve plots all points in between.

Historically, it slopes upward and to the right because short-term rates have been lower than long-term rates. Makes sense. If you buy a 30-year bond, you want to be compensated for your risk in the form of a higher rate.

The yield curve can be normal, flat or inverted. The chart below shows all three. Blue is normal, orange is flat, and gray is inverted.

Yield Curve

A normal yield curve tells us that if we buy a long-term bond, we’re going to earn more interest than a short-term one. With a flat yield curve, it doesn’t matter which bond you buy, because all rates are the same. When the yield curve is inverted, you earn more interest with a short-term bond than you do from a longer term one.

A normal yield curve also signals a strong economy with no known issues on the horizon – ceiling and visibility unlimited. When the curve inverts, trouble awaits. What trouble? A recession. An inverted yield curve has previously been a reliable recession indicator. It’s a sign our economy may be losing steam.

It’s true, an inverted yield curve has been a good indicator. However, the correlation between an inverted yield curve and a recession is not instantaneous. It may take one to two years before a recession occurs after the curve has inverted. It takes time to slow down a $20 trillion economy.

Is the yield curve currently inverted? No. The yield on the one-month T-Bill is 2.334% while the rate for the 30-year T-Bond is 3.176%. This is a normal yield curve, sloping upward and to the right.

Parts of the yield curve are inverted. The 2-year and 5-year rates are slightly inverted. Experts are concerned that this is the beginning of the end, but this is like a driver in Houston who’s worried about a traffic jam in Los Angeles.

The Fed Funds rate is currently yielding 2%, the only rate the Federal Reserve controls. The remaining rates are left to market participants – buyers and sellers. If we compare the Fed Funds rate to all interest rates, the yield curve is normal.

Earlier this year the market sold off because interest rates were rising. Today stocks are selling off because interest rates are falling. The recent price action in the stock and bond markets can be attributed, mostly, to the uncertainty surrounding the trade war between the U.S. and China. Markets hate uncertainty. When investors stare into the abyss of the unknown, they sell stocks and buy bonds. When bonds are bought, rates fall.

The price of oil has also dropped. Lower oil prices coupled with lower rates are a positive for the consumer. The current unemployment rate is 3.7%, so 96.3% of Americans are working. When the American worker pays less at the pump and takes advantage of lower interest rates, they spend money – a boost to our economy.

In the movie Top Gun, Maverick and Goose inverted their F-14 Tomcat, so they could take a picture, and give the bird, to a Russian MIG pilot. After the encounter, they return the plane to normal, fly back to Miramar and buzz the tower. Their inversion didn’t hinder their ability to continue to fly the plane.

Slower growth doesn’t mean no growth. If our economy was travelling at 75 miles per hour a couple of years ago, it may be cruising at 55 MPH today.

Our economy is strong, corporate earnings are robust, interest rates are low, and taxes are favorable. These factors bode well for a higher stock market at some point. Follow your plan, diversify your assets, think generationally, and good things can happen.

Because I was inverted. ~ Maverick, Top Gun

December 7, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process to help our clients pursue a life of purpose.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

 

 

 

3 Percent

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Three is not a lonely number but it is a crowd and a bit odd.  The number three appears in stories like the Three Musketeers and the Three Little Pigs. The Nina, Pinta, and Santa Maria sailed the ocean blue as a threesome.  Famous athletes who have worn the number include Babe Ruth, Dwayne Wade, Candice Parker, Russell Wilson, and Dale Earnhardt.  Let’s not forget the Three Stooges.

Lately, investors have been agitated because the yield on the 10-Year US Treasury Note breached 3%.  Rising rates usually don’t bode well for financial instruments like stocks or bonds but should we be worried?

The last time the 10-Year yield poked its head above 3% was December 2013.  If you purchased the Vanguard S&P 500 Index fund in January 2014, after the 10-Year rose above 3%, you would’ve generated an average annual return of 10.89%.  A $100,000 investment in the Vanguard fund is now worth $155,510.

The yield on the 10-Year Treasury never fell below 3% from 1962 to 2008 and peaked at 15.84% in September 1981. Since 1962 it has averaged 6.23%. Rates are relative and 3% seems low next to the historical average but high when compared to the low of 1.37% it touched in July 2016.[1]

From 1962 to 1981 the 10-Year yield soared 275%.  This period included the Cuban Missile Crisis, the Civil Rights Movement, the Vietnam War and the Iran Hostage Crisis. Despite these headwinds the stock market managed to generate an average annual return of 6.8%.  A $100,000 investment in the Investment Company of America mutual fund in 1962 grew to $547,780 by the end of 1981. Of course, the stock market didn’t go straight up, it fell several times including a 41% loss from 1973 to 1974.[2]

The S&P 500 Index has averaged 10.8% from 1962 to 2018 with interest rates rising and falling. Incorporating a buy and hold strategy in the index, a $100,000 investment in 1962 grew to $34.11 million at the end of March 2018.[3]

Should you be afraid of rising rates? It all depends on why rates are rising. Currently they’re rising for positive reasons because of our strong economy, low unemployment, and robust earnings.

To keep your investments moving forward here are three things you can do now.

Plan. A financial plan will help crystallize your goals and quantify your objectives. It will serve as the cornerstone for your investment portfolio and help guide your through a myriad of market conditions.

Invest. A diversified portfolio of stocks, bonds and cash will help cushion your investments from a rate shock.  Adding international and alternative investments to your account will further balance your portfolio.

Repeat. Rebalancing your accounts once or twice per year will keep your asset allocation intact and your risk level in your desired range.

The American economy continues to thrive, and the long-term trend of the stock market can move higher despite the gravitational pull of interest rates.  Focus on your goals, look to the horizon, and invest often.

“We ignore outlooks and forecasts… we’re lousy at it and we admit it … everyone else is lousy too, but most people won’t admit it.” ~ Marty Whitman

April 25, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management an independent, fee-only, fiduciary financial planning and investment management firm in Austin, TX.  For more information please visit www.parrottwealth.com.

Note:  Past performance is not a guarantee of future returns.  Your returns may differ than those posted in this blog and investments aren’t guaranteed.  The returns don’t include taxes.

 

[1] https://fred.stlouisfed.org/series/DGS10

[2] Morningstar Office Hypothetical Tool

[3] Ibid