General
Why It Is Hard To Predict What Interest Rates Will Be in the Future
The benefits of fixed-income investments should be clearer to everyone after bond prices rose while stock prices declined during recent years. But which fixed-income investments will provide the highest returns? It depends on changes in interest rates.
Can't the experts predict those changes? Not with consistency or certainty.
To understand why it's hard to know how high rates will be in the future, consider the complexity of the fixed-income markets.
Fixed-income securities have a wide range of maturities. The Federal Reserve directly controls rates on loans that banks make to each other for very short periods, literally overnight. At the opposite extreme, corporations issue debt that matures 30 years or more from the issue date.
The direction of very short-term interest rates is determined by the risks of future inflation or recession, as perceived by Ben Bernanke and the other members of the Federal Open Market Committee.
Long-term rates are determined by bond investors. Those folks want a valuable stream of future income and return of their principal at maturity. They fear inflation, because it erodes the purchasing power of the fixed interest payments they receive. They also fear heavy supplies of newly issued bonds that compete with existing bonds for a limited pool of investment dollars.
Economists generally disagree to some extent on the rates of future economic growth and inflation, because their models differ in the treatment of how consumers will react to all of the news that affects buying decisions. Consequently, no one really knows what interest rates will be 6 and 12 months from now.
Cash investments, like money-market funds and certificates of deposit, have stable principal values. You know that you will receive a positive return, equal to the dividend yield or interest rate, on a cash investment. The problem for investors now is that the return on cash is lower than it's been in 40 years.
A bond investment provides not only dividend or interest income but the possibility of a gain or loss on the value of the investment between its purchase and its sale. The total return is the sum of the income and the gain or loss. During periods of rising interest rates some bond investments decline in value so much that the total return is negative.
Fixed-income investors have plenty of reasons to question holding either cash or bond investments. If you've decided that some of your money should have a more stable value than other assets might provide, you have to make several choices. Should maturities be short, intermediate, or long? Should the issuer be the U.S. Treasury, a government agency, or a corporation? Can a portfolio of individual bonds be used, or is a bond fund more appropriate?
At Pleasanton Financial Advisors, we can't predict the course of interest rates, but we nevertheless make decisions for our clients on their fixed-income investments. Please talk to us about how we can help you.