Pre­par­ing your­self for in­ter­est rate hikes

Serve Daily - - EMPOWERING LIBERTY - By Paul Drock­ton

In 2007, the Fed­eral Re­serve started to raise in­ter­est rates by .25 per­cent a quar­ter ex­tend­ing through five quar­ters into 2008. The to­tal in­ter­est rate hike was a mere 1.25 per­cent. The eco­nomic dev­as­ta­tion was be­wil­der­ing. The S&P 500, which rep­re­sents 75 per­cent of all stock mar­ket in­vest­ments, lost over 50 per­cent of its value and so did hous­ing val­ues. Banks and lenders failed as well as Amer­ica’s largest au­tomaker. The ques­tion? How could such a small rate in­crease trig­ger such mas­sive eco­nomic dev­as­ta­tion?

The an­swer lies in the bond mar­ket. The United States bond mar­ket is 300 per­cent larger than the United States stock mar­ket. Bonds are is­sued by both gov­ern­ment and cor­po­rate en­ti­ties. The bond mar­ket is where all this debt is resold to the public and in­sti­tu­tional in­vestors.

When in­ter­est rates in­crease, it de­val­ues all ex­ist­ing debt that pays lower in­ter­est rates. For ex­am­ple, a 10-year bond with a face value of $100,000 at 2.5 per­cent will lose 1 per­cent of its mar­ket value for ev­ery 1 per­cent rate in­crease on new bond is­sues. That is, 1 per­cent for ev­ery year left un­til the bond ma­tures.

If the bond still has 10 years left till ma­tu­rity, it will lose 10 per­cent of its mar­ket value for ev­ery 1 per­cent rate in­crease. Thus, af­ter a 1 per­cent rate in­crease, the mar­ket value of our $100,000 bond could be as low as $90,000. A 30-year bond could lose up to 30 per­cent of its mar­ket value from just a 1 per­cent rate in­crease.

This is what hap­pened to the mort­gage re­sale mar­ket fol­low­ing the fed’s 1.25 per­cent rate in­crease dur­ing five quar­ters. Ex­ist­ing mort­gage debt lost up to 1.25 per­cent times 30 years of its mar­ket value! That is 37.5 per­cent off its face value. A 30-year mort­gage bond orig­i­nally worth $300,000 was dis­counted to a mar­ket value as low as $187,500. Thus, in­sur­ance com­pa­nies and banks that in­vested in those bonds went un­der or were bailed out by taxpayers.

The best way to pro­tect your port­fo­lio is to hedge it with phys­i­cal gold and sil­ver, which in­creased sub­stan­tially in value through­out 2007 and 2008. Then place the re­main­der of your port­fo­lio in a guar­an­teed fund or money mar­ket fund. Money mar­kets will ad­just with rates, yet they can still be dan­ger­ous if rates go up rapidly since they in­vest in bonds with a very short ma­tu­rity (9-12 months).

Photo by Don Pot­ter

The Ab­bing­ton Se­nior Liv­ing Com­mu­nity will con­duct a Model Room Tour on Aug. 20. Pic­tured is the com­mu­nity’s sales trailer.

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