How to Invest in a Rising Rate Environment (Morningstar)

Libor Rising to the Occasion

By Emory Zink | 02-02-17 | 06:00 AM | Email Article

This  article appears in the February 2017 issue of Morningstar FundInvestor.  

The three-month London Interbank Offer Rate (Libor) surpassed 1 percentage point in early January 2017, a first since May 2009 for the widely referenced interest benchmark. The rate is derived by polling roughly 20 or so global banks on a daily basis for quotes of what they would charge other banks to borrow money for three months, dropping the outliers, and calculating an average. The result is used as a base rate for trillions of dollars in financial transactions and provides insight into liquidity and lending risk in the fixed-income markets. When Libor is higher, borrowing is more expensive, and when it is lower, funding is cheaper to access.

The 1% level may look modest, particularly given that Libor touched 5.7% in 2007, but relative to the rate’s post-financial crisis fate—it sat beneath 0.6% from June 2009 until nearly the end of 2015—its more recent ascent was notable. In 2016, it inched upwards, gaining momentum in the second half of the year as money market regulatory reforms hit full stride. The latter spurred many large investors to move assets out of prime money market funds with significant credit exposure into money markets composed of mostly government securities. Redemptions among prime money market funds trimmed demand for commercial paper and certificates of deposit, which in turn raised borrowing costs, and thus Libor’s levels. In fact, many ultrashort bond funds benefited from this structural adjustment, stepping in to snap up higher-yielding instruments at attractive prices leading up to and after the formal Oct. 14, 2016, date that money market reforms kicked in. The flexible  PIMCO Short-Term (PTSHX) and more buttoned-up  Fidelity Conservative Income Bond(FCONX) are two of our favored active ultrashort bond funds that have benefited from these market dislocations.

Bank loan investors have also benefited from the rise in three-month Libor. Minimum payouts for loans—typically referred to as floors—became ubiquitous after the rate plummeted during the financial crisis, and most floors stipulated that loans would continue to pay at least 1% plus a designated spread, even if Libor were to remain below that level. When three-month Libor rises and exceeds those 1% floors, though, as it did in early 2017, and loans began hitting their 90-day resets (typically) their coupons began floating higher to levels of Libor plus that additional yield premium built into each loan. Essentially, as Libor moved higher, floating-rate loans and notes based on that rate began to look more attractive.

The real question now is whether Libor will continue its climb. The U.S. Federal Reserve has hinted that it will likely gradually hike its own federal-funds rate in the coming months and years—Libor typically tracks that level closely during normal market conditions—which implies a trend of higher borrowing costs, if not necessarily a steep one. With prime money markets shrinking, ultrashort bond funds should likely continue to benefit by answering a healthy supply of commercial paper with selective demand, but there is no guarantee that supply won’t stagnate if borrowers seek less-costly forms of financing.

Perhaps even more important, though, is the impact that a rising Libor will have across an even broader expanse of financial markets given that most derivative transaction prices are linked to that rate, as well. It may seem like an obscure financial industry tool, but Libor is ultimately one of the most important rates affecting the entire global financial system.

Emory Zink is an analyst covering fixed-income strategies on Morningstar’s manager research team.

Why You Should Wait: Fixed Annuity Rates are Still Too Low (Morningstar)

The Error-Proof Portfolio:

For Annuities, Timing Is Key

By Christine Benz | 04-12-10

Many investors' hackles go up when you say the word "annuity." They immediately think of variable annuities, many of which are pricey and often sold, not bought. (When the TV program Dateline is using hidden cameras to catch salespeople in the act of peddling inappropriate products to unwitting seniors, it's fair to say that an industry has an image problem.)


But plain-vanilla single-premium immediate annuities deserve more respect. The concept is as simple as it can be: You give the insurance company a slice of your retirement portfolio, and the insurer, in turn, sends you back a stream of income for the rest of your life. You can layer on additional bells and whistles--such as survivor benefits in case you die early in the life of the contract--but they will dramatically decrease the payout you'll receive.


The Value Proposition
The idea of using annuities as a slice of retiree portfolios has been gaining traction in the financial-planning community and among mainstream investors during the last few years. Against the backdrop of a rocky stock market and a shrinking number of defined-benefit plans, annuities' promise of a certain payout holds a lot of appeal. And with bond yields still exceptionally low right now, annuities are also attractive in that they generally deliver a higher payout than what a retiree would receive via a traditional high-quality fixed-income investment.


Annuities also help address the more basic problem that--regardless of the market environment--we're all planning for an unknowable time horizon. None of us knows how long we'll live. And increasing life spans increase the risk that a portfolio of stocks and bonds (that is, one without an annuity) might not last throughout a retiree's lifetime, thereby burnishing annuities' appeal.


Problematic Timing
For all of these reasons, it's become conventional wisdom that SPIAs should be part of retirees' toolkits. Unfortunately, fixed annuities are catching on at what could, in hindsight, be the worst possible time. That's because the payout you receive from an annuity is based on two key factors: 1) the expected life spans of other annuityholders and the likelihood that some of them will die before actuarial tables would suggest; and 2) the interest rate that the insurance company can expect to earn on your money.


The first factor--in essence, the fact that some unlucky people in the annuity pool will die before their time--is why annuities can provide a higher payout than fixed-rate investments. In a pool of hundreds of people, the statisticians know that at least some of the folks who should live into their 80s and 90s will expire in their 60s and 70s instead. Those early decedents will have paid more into the annuity than they've gotten out. Other annuitants, meanwhile, will live well beyond what the actuarial tables would suggest, enabling them to receive more than they've put into their retirement.


The wrinkle is that people are living longer, and insurance companies are having to spread the money in the annuity pool over more and more very long lives, so increasing longevity will have the side effect of shrinking the payouts for everyone. (As a side note, an interesting body of research indicates that annuity pools include significant adverse selection--that is, the people who are most likely to buy an annuity are also likely to live much longer than actuarial tables would suggest. That may be because those most attracted to annuities may have longevity in their families, or perhaps there's a correlation with wealth and better health care.)


That trend will provide a long-term headwind for annuities, but it shouldn't have a significant impact on the timing of when you buy an annuity. The other component of annuity payouts--the interest rate the insurance company can expect to earn on your money--is more problematic. If you buy an annuity today, the currently ultra-low interest-rate environment will depress the payout you receive. (It's not a perfect analogy, but it's somewhat akin to buying a long-term bond with a very low coupon. Rates may go up in the future, but you'll be stuck with your low payout.) The average fixed annuity rate plunged from 5.55% to 3.94% between December 2008 and December 2009, according to National Underwriter.

What to Do?
For those who like the concept of an annuity but are concerned about the effect of low interest rates on payouts, one possibility is to ladder your investments, essentially dollar-cost averaging in to mitigate the risk of buying an annuity when interest rates are at a secular low. If, for example, you were planning to put $100,000 into an annuity overall, you could invest $20,000 into five annuities during the next five years. Such a program, while not particularly simple or streamlined, would also have a beneficial side effect in that it would give you the opportunity to diversify your investments across different insurance companies, thereby offsetting the risk that an insurance company would have difficulty meeting its obligations.


Alternatively, a prospective annuity purchaser could simply wait until fixed-income interest rates head back up toward historical norms. While fixed-income yields have recently begun to climb, they're still extremely low relative to historic norms.

For Real - How Much is Inflation? (from icma-rc.org)

Food and Energy Prices Driving Overall Inflation
Chart of the Week for March 25 - March 31, 2011

Inflation is a general increase in prices and is carefully monitored to gauge economic health. Too much, too little, or unexpected changes in inflation is generally thought by economists to be detrimental to the economy. Inflation is typically measured by the Consumer Price Index ("CPI"). This index is calculated by measuring the average change in price of a given basket of goods.

Core CPI is the same index, with volatile food and energy prices excluded. The chart above illustrates the trend in these two versions of the CPI over the past two years.

Core CPI remained around 2% in 2009, but falling food and/or energy prices drove the overall CPI into negative territory for much of the year.

In 2010, Core CPI dropped to under 1% with food and/or energy prices remaining fairly stable until the fourth quarter.Thus far in 2011, supply constraints, primarily stemming from the improving global economy and political unrest in the Middle East, have propelled a rise in food and energy prices. This change has been a key factor in the overall CPI increase from 1.5% in December 2010 to 2.1% in February 2011.

The Federal Reserve Open Market Committee ("FOMC") met on March 15, 2011, and issued a press release stating its expectation that the upward pressure of energy and other commodity prices on inflation will be transitory. Therefore, the FOMC will continue purchasing longer-term Treasury securities and maintaining a target range for the federal funds rate at 0 to 1/4 percent. However, the FOMC will act to stem inflation, should it threaten the economic recovery.

While Overall and Core CPI remain low, they have been trending upwards. This change has been felt by consumers in higher prices of food and energy and is being monitored by Federal Reserve.

© Copyright 2011 ICMA Retirement Corporation, All Rights Reserved.

Taking Advantage of Mortgage Rates Now (New York Times)

March 19, 2010
When Not to Pay Down a Mortgage
By RON LIEBER

This week, the Federal Reserve reaffirmed its intention to stop buying mortgage-backed securities, signaling the likelihood that the mortgage rates you can get today are as good as they’re going to be for a long while. Once the Fed stops buying, after all, rates are likely to go up.

And current rates are quite good. At about 5 percent, in fact, they’re so good that they’ve helped change the age-old debate over whether homeowners should make extra mortgage payments to pay off their debt well before their loan periods are up.

Back when rates ran at 7 or 8 percent, making extra payments offered what amounted to a guaranteed return on your money. When you’re ridding yourself of debt that costs you much less, however, it’s easier to imagine a future when you could more easily earn a higher return by investing those potential extra mortgage payments someplace else.

Meanwhile, at a time when just about everyone knows someone who is unemployed or who owes more on a home loan than the house is worth, keeping extra cash someplace more liquid than a mortgage seems like a safer approach.
So is the case against extra payments closed for good, given that so many people have locked in rock-bottom mortgage rates for the long haul?

The answer depends on two things: how likely you are to leave the extra money in savings and how good it would feel to wipe your debt out years earlier than your mortgage requires.

THE BASICS First, let’s dispense with the standard boilerplate. Don’t even think about making extra mortgage payments unless you’ve paid off higher-interest debt. Credit card debt is the easiest win here.

Also, if you’re not saving enough to get the full match from your employer in a 401(k) or similar account, increase your savings there first. And don’t make extra mortgage payments if you don’t already have a decent emergency fund set aside.

YOUR REAL INTEREST RATE Now, take a look at the interest rate on your mortgage. That 5 percent? It’s not your real rate if you get some of the interest back each year in the form of a tax deduction.

Let’s say you have a household income of $175,000 and are paying 35 percent of that in total to the state and federal tax collectors. If you pay $20,000 in mortgage interest each year on a loan that charges 5 percent, the deduction effectively brings your taxable income down to $155,000.

As a result, you’re paying $7,500 (35 percent of $20,000) less in taxes than you would have without the deduction. So ultimately, you’re not really paying $20,000 in interest at all; your net cost is $12,500 after you subtract the $7,500 tax savings.

And that makes your effective, after-tax interest rate on your loan just 3.25 percent, which is simply 35 percent (your tax rate) less than the original 5 percent.

BETTER RETURNS? So any money you set aside in lieu of making extra mortgage payments would need to earn more than 3.25 percent annually. That seems like a reasonable possibility in the future.

In fact, you could have done that well during the supposedly lost decade we just finished. Vanguard Wellington, for instance, a popular low-cost mutual fund that holds about 65 percent stocks and 35 percent bonds and other short-term securities, earned an average annual return of 6.15 percent in the 10 years ended Dec. 31, 2009.

The Vanguard Balanced Index Fund would not have outperformed our 3.25 percent benchmark, however, as it only returned 2.64 percent over the same 10-year period.

STORING THE SAVINGS Wouldn’t taxes eat into the returns from the money you’d save instead of making extra mortgage payments? Not if you place it into an account shielded from taxes. A Roth individual retirement account would fit the bill here, as would a 529 college savings account or health savings account.

Bruce Primeau, whose note to his financial planning clients at Wide Financial Group in Minneapolis on this topic inspired me to re-examine it, adds that this isn’t simply about keeping more assets under his watch so he can earn a better living. “I’m not telling them that the money has to come to me,” he said. “A 401(k) match beats the return on paying a mortgage off automatically. There’s real estate and buying employer stock through a purchase plan at a 15 percent discount and all kinds of things.”

Then you need to preserve those savings. When extra money goes toward a mortgage, it’s hard to get at it when the urge strikes to flee to an Asian beach for a few weeks of playtime. If the money is not locked up in retirement or college savings, however, you may be tempted to spend it.

THE LIQUIDITY PROBLEM Capital-gains taxes might eventually come due with some of these investments, and the rate could well rise above the current 15 percent long-term rate before too long. Still, having some of your savings in a taxable account makes sense for several reasons.

If you hit a stretch of long-term unemployment after having plowed most of your extra cash into paying down your mortgage, your bank probably won’t pat you on the back for being a good saver and give the money back to you. Nor is it likely to let you borrow it through a home equity loan if you have no income with which to repay it.

Elaine Scoggins, who had the mortgage department chief reporting to her at a bank before she became a financial planner, suggests imagining a situation where you need to move quickly but can’t sell your home or extract equity to use as a down payment in your new town. Given that possibility, why create more home equity through extra mortgage payments than you have to?

“The whole housing debacle has reminded us all, including me, that real estate is not liquid,” said Ms. Scoggins, who is the client experience director for Merriman, a planning firm in Seattle. “And it takes cash to support it.”

Those who have used their cash in an attempt to be conscientious have learned some tough lessons, meanwhile. Imagine people who scraped together a 5 percent down payment and bought a home in Florida or Arizona in 2005 and then made extra mortgage payments the first two years to try to increase their equity. Now, post-collapse, they owe, say, 30 percent more than their homes are worth and need to seriously consider walking away from the loan — and all of those extra payments.

REASON AND EMOTION So the reasoned case for making no extra payments is very strong. But there’s one counterpoint that almost always carries the day, even when there’s only a mild risk with the financial strategy of putting extra money elsewhere.

And it’s this: I need to be able to sleep at night.

Even Mr. Primeau concedes here. “Emotionally, you’re right, and financially I’m right, and emotionally, you win,” he said. “If emotionally, people want to pay down their debt, then that’s what I help them to do.”

If you’ve just started paying down your mortgage, any extra payments should go toward principal (make sure your mortgage company is applying it properly). That will have the effect of shortening the term of your loan from, say, 30 to 25 years, depending on how many extra payments you make. The extra payments won’t lower your monthly payment, but they will reduce your balance.

Many people who are years into their mortgages — and perhaps paying less in interest and getting less of a tax break as a result — tend to develop stronger feelings about making extra payments. Those feelings are often even more acute as retirement approaches and homeowners become determined to quit work with no debt to their names.

Those who do retire their debt rarely regret it or wring their hands over the big gains they might have scored by investing the money elsewhere. Tim Maurer, a financial planner and co-author of “The Financial Crossroads,” describes the feeling that washes over people who have paid their last mortgage bill as “beholden to no one.”

So he doesn’t feel as if it’s his business to separate people from their emotions if they feel strongly about working toward a debt-free existence. “The whole point of planning is to make life better,” he said. “It’s not to have more dollars at the end of the day.”

Rise in Short Term Interest Rates - Get Ready (AP)

Regulators tells banks to prep for higher rates
By JEANNINE AVERSA
AP Economics Writer

Financial regulators told banks Thursday to have procedures in place to minimize their risks from loans when rock-bottom interest rates start to rise.
The advisory came from the Federal Financial Institutions Examination Council, which includes the Federal Reserve, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and the Office of Thrift Supervision.

The advisory wasn't meant to signal any upcoming change in interest-rate policy by the Fed.

To nurture the budding recovery, the Fed has slashed a key bank lending rate to a record low near zero, where it has been for a year. When the economy is on firm ground, the Fed at some point will start boosting rates. Some economists think the Fed might begin to raise rates later this year to safeguard against any inflation problems.
It's unusual for the council to issue such an advisory. The last time it did so was in 1996, a Fed spokeswoman said.

"In the current environment of historically low short-term interest rates, it is important for institutions to have robust processes for measuring and, where necessary, mitigating their exposure to potential increases in interest rates," the council said in the advisory issued Thursday.

Higher interest rates make it more expensive for banks to borrow and increase their costs of doing business. The council suggested that banks make sure they have sufficient capital cushions to protect against any possible losses.

"In this challenging environment, funding longer-term assets with shorter-term liabilities can generate earnings, but also poses risks to an institution's capital and earnings," the council said.

The council said banks should be testing their risk-management systems for scenarios including instantaneous and significant changes in interest rates.

Deficiencies in banks' risk-management systems - along with lax regulation - have been blamed for contributing to the financial meltdown. The crisis, the worst since the 1930s, was triggered in 2007 when home mortgages soured as the housing market collapsed.