Fed To End Quantitivate Easing

Probably the biggest thing the U.S. government has been doing to stimulate our economy in the wake of the 2008 financial crisis and recession has been something called "quantitative easing".  It is pretty much the practice of the Fed buying bonds from the Treasury to stimulate the economy.

Those bonds are sold to give our government more operating cash, to either pay bills coming due or spend the money on necessary services and/or projects that our leaders believe will be stimulative to the economy.  Sometimes, like I understand is the case now, the Federal Reserve actually prints new paper money with which to make the purchases.  The risk is inflation in the future, but such risk is taken with the intention that the short-term stimulus effects are worth the risk.

Now the economy is growing.  Slowly and not necessarily surely, but measurably and postively.  The Fed is thus in the middle of tapering the Quantitative Easing, creating a glidepath to ending QE (it had been buying $85 billion worth of bonds every month).

But last week one normally hawkish Fed big shot was surprisingly outspoken--and dovish.  He said the Fed would not necessarily end QE as planned, impying that the Fed would help the securities markets if need be (we were in a market decline last week, and he is thought to have been speaking to that matter with intent of reassuring investors)...  Word is, though, that most of his peers (including those with a vote on the matter, which I believe this one fellow does not have) intend to end QE for sure.

In short, the nFed is said to be on track to end QE, even if one of its members may have spoken his opion of what should be done instead of saying what the Fed will do.

Bill O'Grady (not Bill Gross--I cite each pretty often and want to be clear:  O'Grady is the global investment strategist/thinker, Gross is the manager of bond portfolios and mutual funds) writes today about this.  See the second and third paragraphs in the item linked here:  http://confluenceinvestment.com/assets/docs/2014/daily_Oct_20_2014.pdf

Okay, I wanted you to know the basics in case it is not clear.  I hope it helps.  Please contact me with any questions.  Thank you.

--Gary

Gary Partoyan

Potomac Wealth Strategies, LLC

(703) 746-8195 direct

Visit us online for helpful ideas and information!

Bonds Explained (briefly)

The Fed Funds Rate is at historic lows and interest rates will eventually rise.  That will cause downward pressure on bond prices.  Bonds, though, are usually considered the safer, more stable part of a diversified portfolio.  So, professionals and individual investors alike have bonds on the brain these days…

Bonds Explained, briefly:

1.       Bond investors are essentially making loans to companies, governments, and municipalities

2.       In exchange for their temporary investment (a few months on up to 30 years or more; mostly 1-10 years), bond investors are paid interest (usually monthly, sometimes just yearly, and maybe at other times).

3.       The longer the bond, or the riskier the bond, the higher the interest rate paid.

4.       Bond investors get their money back at the end of the term, in addition to interest; sometimes there is no interest paid ongoing but instead it’s included with the principal repayment at the end.

5.       If the bond issuer has financial trouble, bond investors may not get some or any of their money back; that's rare, though, even in the case of "junk bonds".

6.       It is complicated for individual investors to build and manage their own bond portfolios.

7.       High-net worth individuals and institutional investors can get much better pricing.

8.       Bond funds have costs that eat away at income and total returns, but there are several bond funds that have excellent cost-justification track records (I am constantly searching for and evaluating such).

9.       Bond funds, however, do not offer the actual return of investment; instead, bond funds have a "net asset value" (like a share price) that fluctuates indefinitely.

10.   So, there are trade-offs, and my professional opinion is that bond funds with excellent track records and consistent management are very suitable for most investors

Interest Rate Risk Explained, briefly:

1.       In short, bond prices rise when interest rates drop, and they decline when rates rise.

2.       That is because bond interest rates move up and down as the prevailing interest rates (fed funds rate, treasury bonds, etc.) change.

3.       Different types of bonds will move more or less with prevailing rates for various reasons.

4.       Bond holders can wait for their bond to mature and get 100% of their money back after already getting the interest rates promised.

5.       Bond prices, meanwhile, fluctuate as bond rates move because of the secondary market for bonds:

a.       You buy a bond today that pays 3% interest, but, when rates rise, someone else looking to buy a bond next year can get something similar to yours that pays a higher rate.

b.      If you want your investment back before the bond comes due, someone might be willing to buy your bond instead of a new one.

c.       But since yours has a lower rate than what they can now get, they'd only pay you less for your bond than they would for a brand-new one offering a higher rate.

d.      So, bond prices decline when interest rates rise.  Likewise, though, bond prices rise when interest rates fall.

6.       You might have a very safe and sound bond portfolio, but its value may fluctuate between the time you buy the bonds and get your money back.

7.       But holders of individual bonds do get their money back (plus interest already paid or included with the principal repayment at the end) if they hold to the end; that is, of course, unless the bond issuer goes bankrupt or has major financial trouble.

8.       Bond fund holders would have to ride-out the interest rate fluctuations and/or the bond fund managers would have to successfully adjust the portfolio in order to keep the fund's NAV going up (or from going down) in a rising-rate environment.

9.       Even if rates rise and bond prices fall, you can still make money (and keep getting interest income) from bond funds.

10.   The better bond funds have methodology and strategy that work well, and track records to demonstrate that.

11.   There are no guarantees that a great bond fund manager will succeed all the time, of course.

Bottom line:

1.       Bonds are not as safe as they usually are because interest rates are likely to rise.

2.       But bonds remain one of the three most important parts of any diversified portfolio.

3.       Portfolios of individual bonds are difficult for most individual investors to assemble and manage; bond funds have drawbacks but are good choices for many.

4.       Bond index funds have been touted for their low-costs and benchmark-matching performance (or close to it), but they pose increased risks in this likely rising-rate environment.

5.       Actively-managed Bond mutual funds offer a lot of advantages to individual investors—diversification, potentially cost-justifying performance, and convenience.

6.       I work hard to find and use only the best bond funds that are likeliest to perform well going forward.

7.       PIMCO is an example of a "active" bond fund manager that has an outstanding track-record

a.       While I have no obligation to keep using PIMCO funds (or those of other managers I favor), I expect PIMCO and some others will remain a key part of the bond portion of my Flex and Strategic portfolios.

What I'm Tracking Now--Interest Rates

I'm keeping my eye on interest rates. If they appear to be going up, we may need to adjust the bond portion of our portfolios, potentially rapidly and significantly.

Remember, bond prices drop when interest rates rise. Imagine fleeing the stock market for the bond market in order to preserve your nest egg, as millions of investors have done with zillions of dollars in recent years, only to have the nest egg reduced by bond prices dropping if/when interest rates rise? Pretty awful scenario, but also not unlikely to happen.

To defend against this "hurt even though I sought shelter" potential, we need to anticipate the interest rate moves.

If the Fed changes its language vis a vis fed funds rate, basically from the current "low for an extended period of time" to something like "for a while longer", that will have my attention.

If the newly-issued US Treasury bonds don't sell as much or as quickly at auction, indicating we might need to offer higher interest rates in order to "move the product", that will have my attention.

The Fed is unlikely to raise rates proactively until the economy is growing enough for inflation to become a concern. But rates may rise in the auction markets anyway, if our bond buyers (like China) determine that investing in the USA is more risky than usual. You see, they'll demand more for their investment, and we'll have to offer higher rates.

Either scenario will do damage to the net worth and account balances of investors positioned in the wrong kind of bonds or bond funds.

I seek to protect clients by keeping eye on what might cause the fire, not just by looking for clouds of smoke.

More On Interest Rates and Bond Investing

I'm preparing for rising rates. While I don't expect the Fed to raise 'em this year, or even in 2011, it is bound to happen some day. Rates are as low as they can go (the Fed Funds Rate is now 0-.25%).

There is also the market-forces factor. If the USA keeps needing to borrow money, our national credit rating could be at risk and that, along with the flood of additional bond issues to the global markets, could naturally force rates up, regardless of the Fed's action.

Well-managed bond "ladders" and bond mutual funds can mitigate the "interest rate risk" of owning bonds. Remember, bonds are usually less risky than stocks and are used for the more conservative and/or the income-oriented portion of an investor's portfolio. But rising rates hurt the market value of bonds, so portfolio values can decline when rates rise.

There are many ways to address these scenarios, and I have my ducks in a row. If we hit rough weather in the bond markets, we know where the lifejackets and life boats are, and how to use them.

Interest Rates and Bond Risk

The Federal Reserve is tasked with two primary objectives: maintain price stability, and maintain high employment.

Maintaining price stability means, simply, keeping inflation pretty low without pushing us into deflation.

Maintaining high employment... well, that means keeping unemployment low (not sure how else to explain that obvious objective).

In both cases, the most effective tool at the Fed's hand is raising or lowering the interest rates. Lower rates stimulate the economy because it makes it easier/more affordable for people and businesses to borrow money. Raising rates tames inflation by slowing down the economy.

But interest rates affect the value of bonds. Bonds, as I've posted here before, are thought to be the "safe" place to invest, but they do fluctuate in value. Rising interest rates force bond prices lower; falling rates lift bond prices.

Most folks buy bonds in order to get predictable income streams, not capital gains. Hold a bond to maturity, in fact, and you get your original money back. Your benefit was the income the bond paid while you owned it.

So, if interest rates are so low, aren't bonds scary now--won't they be likely to go down in value? Yes. If and when the Fed starts raising interest rates.

But that should only happen when the economy starts growing too fast again. We're just hoping it's really even starting to grow now. Some experts think it won't be for another year or two that the Fed will start raising rates.

So, this is potentially good for bond investors who need income or who seek relative safety compared to the volatile stock market. Alas, other forces could work against interest rate stability. If the USA's spending remains in deep deficit mode, we might need to offer higher rates on our more risky Treasury bonds when we sell more to fund our ongoing deficits.

The key is to know what you have and to have an exit plan. Most individuals should not tinker with individual bonds right now. It would be better to have a private portfolio manager run things, or to use a reputable and successful bond mutual fund.

Counterintuitive Is Not Just A Cool-Sounding Word.

It is the way to describe many of our best investment choices right now. With stock markets in volatile moods and economies on the ropes, investors are wondering where to invest. Bonds. That's usually the call when stocks get too scary.

But bonds are not always safe. The better-quality bonds do pay you back your money, with interest, but if you need your money back before the bond matures, you can make or lose money. Sometimes a lot.

When interest rates sink, such as during a recession when central banks want it to be easier for businesses and individuals to borrow money (to hopefully stimulate the economy), the price of bonds you hold will go up if the interest rate you have is better than what newly-issued bonds would offer. The reverse is true when things are going perhaps too well economically and the central banks decide to slow things down a bit.

Well, rates also rise by accident, when things are bad--not just when they're too good. If a usually economically-sound country keeps issuing bonds to pay for government services that are not funded well enough by tax revenue, that indicates to investors that the country might be facing difficulty. Between that and an increased supply of new bond issues, the demand/supply ratio is affected. When there are not enough buyers, sellers either lower their prices or sweeten the pot. Offering higher yields is the sweetening the pot, and selling for less than face-value (the earlier scenario) is the lowering of the price.

If the USA is taking on massive amounts more debt, there's a leveraging of the increase in yield it must offer to attract investors. That pushes down the value of the bonds one might already hold... and that's the kind of nest egg damage a lot of folks seek to avoid when they go into bonds in the first place.

So, what to do?