In a move that most experts expected, the Federal Reserve decided today to leave the target for the federal funds rate—what the Fed charges banks to borrow money on a short-term basis—between zero and 0.25 percent, where it has been since December 2008. The Fed also repeated its pledge to keep rates low for an "extended period."
Although it's uncertain how long this extended period will last, few are expecting a rate hike in the near future. "Everyone knows rates can't stay this low forever," says Doug Harsham, vice president of municipal trading at Raymond James. "It's just a question of when it's going to change and how drastically."
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Jeff Tjornehoj, Lipper's research manager for the United States and Canada, says he's skeptical that the Fed will raise rates this year. "I think they're a long way from raising rates," he says. "I think that the point where they raise rates is where we start to see inflationary pressure or the economy starting to advance very strongly."
Without noticeable job growth, Tjornehoj says there isn't a strong push for an inflationary environment. "We haven't seen inflationary pressures because we really haven't seen much in the way of job growth," he says. "Two-thirds of the inflationary pressure is from wages." He isn't looking for a rate hike until at least next year.
The potential for rising interest rates has important implications for bond fund investors. Every investor should be aware of the risks associated with investing in different types of bonds and how interest rate changes can alter the value of their investments.
The Fed sets a target (currently between zero and 0.25 percent) for the federal funds rate, which only directly affects short-term interest rates. If the Fed decides to raise the federal funds rate, that increase will reverberate throughout the bond market and affect different types of bond investments. An increase in the federal funds rate will lead to increases in various rates like the treasury bond rate and the corporate bond rate.
"The Federal Reserve controls the federal funds rate so they set short-term rates via targeting of the federal funds rate, and that's reflected in a lot of the returns that investors will see on cash and money market funds and other short-term investments," says Rob Williams, director of income planning for the Schwab Center for Financial Research. "The Fed sets the tone, and then bond markets tend to follow."
Williams says that for retirees and other investors whose primary goal is saving, a rise in interest rates would be welcome news because yields of money market funds are at historic lows. An increase in interest rates means higher yields for these types of funds.
No one is certain when the Fed will increase rates, but in the meantime, Williams says investors need to understand the risks involved with investing in long-term bonds. Because yields on short-term investments have been so low for an extended period of time, some investors have abandoned them in favor of higher yields of longer-term bonds.
"When [investors are] grappling with a low interest rate environment, the temptation is to try to look for yield in types of bond investments that might be a little more riskier than they anticipate," Williams says. When interest rates rise, the price of bonds fall. Investors need to be aware of the average maturity of the holdings in their bond funds. The longer a bond's maturity, the more susceptible it is to interest rate hikes. For many investors, bonds are meant to be used as a defensive part of their portfolio to lessen the volatility that comes with other investments like stocks.
Joni Clark, chief investment strategist for Loring Ward, says bond investors need to think about the long term. "If you're a shareholder in a bond fund, you actually want interest rates to rise because you're effectively a lender and you want higher yields," she says. "When an interest rate rises, after the initial price shock, it will benefit bond investors in the long term."
Clark generally recommends that investors stick to short-term bond funds. "If you're investing in a short-term bond fund, there's a lot more turnover in that bond fund because you've got short-term maturity bonds, and they're continuously maturing and the principal is being taken and reinvested," Clark says. Long-term funds are more vulnerable because of the time it takes for the bonds to mature.
Those who are investing without a specific time horizon are the ones who are most likely to be hurt by a rise in rates. For instance, if you need money in two years, Clark says you shouldn't invest in funds that have longer than a two-year duration. "The only person it's really going to hurt is that person that's going to need the money in two years and maybe they were invested in a five-year duration bond fund," she says. "It could hurt them, but as long as an investor is in there for a longer period of time, and the time horizon is greater than the duration of their bond fund, they're going to be fine and their income will offset [price declines] over time."