Preparing yourself for interest rate hikes
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).
The Abbington Senior Living Community will conduct a Model Room Tour on Aug. 20. Pictured is the community’s sales trailer.