- 2001: Volume 10, No. 4 It All Starts With Interest Rates

Before Brocade, there were bonds, before Intuit, there were interest rates. No less than Albert Einstein, in fact, proclaimed compound interest to be the greatest product of the human mind. As further proof of his genius, he stuck with simple things, like the origin of the universe, and left financial markets alone. Since few of us have that luxury, we need to understand the nature of interest rates, how they affect our lives and our investments, and how we can take advantage of this knowledge—especially at a time in which bonds have outperformed stocks for the first time in years.

Both A Borrower And A Lender Be
At their most basic, interest rates are nothing more than the price of money. Why, besides the fact they can, do central banks like the Federal Reserve believe they can influence economic growth and either speed up or slow down economic growth by ratcheting interest rates higher or lower?

The answer lies in the bargain we all make with ourselves between current and future consumption. If we earn a dollar today, we can choose between spending it and saving it. Higher interest rates induce us to save and thereby defer current consumption. This both slows the economy at present and lays the foundation for future consumption if the savings are invested productively.

Oddly enough, societies always have been rather ambivalent about this whole process. While nearly all cultures celebrate the virtues of thrift —just think of the ant and the grasshopper—nearly all major religions have had some sort of ban on usury, however defined. Even today, the U.S. tax code distinguishes between wage and salary income and investment income; investment income comes in for harsh treatments such as the double taxation of dividend income.

Capital markets also balance the supply and demand for funds over different maturities, and most of us occupy different stations along this yield curve, or the map of interest rates over time, simultaneously. For example, how unusual would it be for an individual to be a lender for a six-month bank certificate, a borrower for a five-year auto loan and a 15-year mortgage, and a lender in a 401-K plan? There’s nothing at all inconsistent in such a profile; we can judge each of these actions separately and justify them on their individual merits. The bank CD may be for an amount too small to purchase the car, while the auto loan may be made in recognition of the rapid depreciation schedule of cars. The mortgage may be a leveraged investment in real estate, and the 401-K is a tax-advantaged deferral of consumption into retirement years.

It’s probably safe to say each one of these transactions is at a different interest rate. Normally, long-term rates, say 10 years, are greater than short-term rates, say two years. This positively sloped yield curve compensates lenders for the greater risk of inflation over long periods of time. However, should the Federal Reserve wish to slow the economy for whatever reason, short-term rates can rise over long-term rates. This is referred to as an inverted yield curve.

Interest Rates and Implications For Investing
All investments have two sources of return, an ongoing income stream and change in the underlying value of the asset, or capital gain/loss. Stocks provide income through dividends, and these dividends can grow as the corporation becomes more profitable. However, this long ago ceased to be the primary impetus for investing in stocks; the real reason is the prospect of capital gain.

Unlike stocks, where the passion is for growth, bonds’ primary purposes are provision of current income and preservation of capital. The coupon rate on most bonds is fixed—hence the common term "fixed income"—and bonds promise to pay a fixed face value when they mature.

As a result, the principal risk of a bond, other than the issuer defaulting, is adverse movement in interest rates. Some of the effects of interest rates are easy to describe and work all of the time. They derive from the single equation for the price of a coupon-paying bond:

1. Price and yield move inversely.
2. Longer-maturity bonds have greater percentage price changes for a given change in interest rates than to short-maturity bonds.
3. The price sensitivity of bonds increases with maturity, but at a decreasing rate.
4. Bonds with lower coupon rates experience greater percentage price changes for a given change in interest rates.
5. The price increase produced by a fall in interest rates will exceed the price decrease produced by a rise in interest rates of the same magnitude.

These principles and others can be boiled down to a single measure, duration, which is defined as the weighted average of the present value of a bond’s cash flows. Long duration bonds are more sensitive to interest rate changes than are short duration bonds. In the chart in Figure 1, the 20-year bond has both the greatest gain at low interest rates and the greatest loss at high interest rates. Professional bond managers for pension funds, insurance companies, focus on their portfolio’s duration as a way of handling interest rate risk (see Figure 1).

Figure 1:

It is important to remember that bond managers have different objectives than do their stock manager cousins. Stock managers will lose their funds under management if they underperform the market or their nearest competitors, which is why they must jump into the market at the first sign of a rally, regardless of market fundamentals. Bond fund managers will lose their assets if their duration remains long as interest rates rise, which is why they are so quick to shorten duration at the first hint of rising interest rates.

Interest Rate Movement
How do we know when interest rates will be rising or falling? This is perhaps the most difficult problem in all of finance since it involves so many dynamic feedback loops. A stronger economy will increase credit demands on the part of borrowers, but it will increase the supply of funds from individual savings and corporate profits as well. A Federal Reserve policy of lowering short-term interest rates will increase the supply of funds available, but it will also lead to heightened inflationary expectations and a weaker dollar over time, and both of these will push long-term interest rates higher.

As a result, short-term interest rates tend to move in one direction for sustained periods of time, as seen in the chart in Figure 2. Longer-term rates, however, tend to jump about abruptly as expectations change with every little piece of news in the market. In trading terms, short-term interest rates are trending, while long-term rates are mean reverting.

Figure 2:

How To Protect Yourself
Since interest rates are a component of stock prices—a stock’s value is the discounted stream of expected dividends—all classes of financial assets are interest rate sensitive. Generally speaking, growth stocks, whose dividend payouts will be further in the future, are more sensitive to interest rate increases than value stocks, whose earnings stream is of a shorter duration, will be. Of course, periods of frantic earnings growth, such as seen in 1999, can allow very speculative growth stocks to outperform value issues for long periods of time. Stock traders can buy high-dividend, low price-to-earnings stocks when they expect higher interest rates and low-dividend, high price-to-earnings stocks when they expect rates to fall.

With the exception of Treasury securities, bonds tend to be less liquid than stocks, but there’s a world of instruments with which to express your outlook. Sophisticated, risk-seeking traders can trade interest rate futures at almost any maturity; buy the futures when you expect rates to fall, and sell them when you expect rates to rise. Options on these futures trade as well; you can buy a call option when you expect rates to rise and a put option when you expect rates to fall. Moving down the risk curve, traders who expect rates to fall can buy a zero-coupon bond and sell a high-coupon bond of the same maturity; the trade is reversed when rates are expected to rise. There are even exchange-traded fund like securities offered by the Amex, Bond Index Notes®, which trade like a stock and whose price is linked to bond indexes.

Bonds only look simple; in fact, a good fixed-income trader has to understand the Federal Reserve’s monetary policies, the course of the U.S. and global economies, equity and currency markets, and his own risk preferences and sophistication level. That’s the bad news. The good news is trades exist for every level of risk and sophistication for any environment. A sample of the choices available is listed in the above table.

Both buy and sell trades are listed. Does this mean you have to do both? No, most investors should be content with lending their money, the "buy" side of the equation. Any time you sell an interest rate instrument, you are borrowing. In reality—and this is the tough part—every time you take cash out of your pocket to buy something, you are borrowing at your opportunity cost, say a bank CD or money market rate, to lend in the bond market. The "sell" side in the table to the left lists transactions you could undertake instead. These are the choices large bond traders have to make every day.

Bonds and other interest rate instruments should be the foundation of most investors’ portfolios. They aren’t totally safe—they’re subject to interest rate risk, inflation, and default risk (non-Treasuries)—but they’ll cushion you from Nasdaq-style ups and downs. We’re reminded every time stocks swoon of Will Rogers’ line, "It’s not the return on the principal I’m worried about. It’s the return of the principal."

Interest Rate Outlook	Risk Preference	Sophistication Level	POSSIBLE TRADES
			Buy	Sell
Fed tightening, curve inverting	High	High	Bond Call Options	Eurodollar call options
		Low	Zero-coupon bonds	High-yield corporate bonds
	Low	High	Amex bond index notes	Two-year call options
		Low	Five-year notes	Two-year notes
Fed loosening, curve steepening	High	High	Two-year note futures	Bond call options
		Low	High-quality corporate notes	Two-year notes
	Low	High	Foreign bonds	Treasury notes
		Low	High-quality corporate notes	Treasury bills
Fed stable, long rates rising	High	High	Interest-only mortgages	Bond futures
		Low	Bond put options	High-quality corporate bonds
	Low	High	Commercial paper	Treasury notes
		Low	High dividend stocks	Treasury bonds
Fed stable, long rates falling	High	High	Principal-only mortgages	Bond put options
		Low	Treasury bonds	Treasury bills
	Low	High	High-yield corporate bonds	GNMA pass-throughs
		Low	Bond mutual funds	Treasury bills

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management (www.CapitalistPig.com), a Chicago-based hedge fund, and the author of Greed is Good: The Capitalist Pig Guide to Investing.