Investors worry about Federal Reserve Bank policy and rising interest rates. The question has been "how much, how soon," not "if?"

Investors worry about Federal Reserve Bank policy and rising interest rates. The question has been “how much, how soon,” not “if?”

Over the last 30 years the median average interest rate paid on benchmark 10-year Treasury notes is 5.54%. At 2.148% on May 8, 2015, rates continue well below average. Are we willing to join the talking heads calling for dramatically higher interest rates near term? No. Instead we make a case for lower than average rates for the foreseeable future.

Weak 4th-quarter 2014 growth pushed the 10-year Treasury yield to a 20-month low of 1.67% in January. The rate is up roughly 48 basis points currently, but still low historically. During the April Federal Open Market Committee (FOMC) meeting, the word “patient” dropped from policy statements so Fed-watchers saw the possibility of a June increase in interest rates. That seems unlikely.

First quarter GDP tipped into the negative column by some measures given bad weather and a West Coast port slowdown, among other factors. Recent reports have employment and stock market averages looking up. But number gazers still contend with yin and yang in determining if the glass is half-full or half-empty.

Dollar strength and weakening currencies elsewhere constrain exporter profits while attracting foreign capital to U.S. bond markets, holding down our interest rates. Ten-year government bond rates in France, Germany, Japan, and the U.K. are well below U.S. rates. Even basket-case Italy and Spain are paying lower rates on 10-year paper than Uncle Sam. If the Fed hikes rates, our dollar appreciates further, making the U.S. less competitive in global markets.

Inflation continues below the Fed target of 2% and some inflation hedges have lost luster. American Eagle gold coins are down in price 7.6% from a year ago and Englehard Industrial gold is down 7.7%. Silver is off -14% from a year ago,

platinum, -20%. Other commodities—copper, steel, tin, cotton, corn, soybeans, wheat, oil, gas—are below one year ago levels. Cost-push and wage-price inflationary pressures are restrained.

In summary, there are 18 developed countries whose 10-year yields are below that of the U.S., making American rates attractive by comparison. Add the credit rating of the U.S. and a strengthened dollar and one can conclude that global needs to park safe money may continue high demand for American debt, keeping rates low no matter what the Fed does. Our central bank can only do so much in influencing interest rates.

But no trend last forever and historically low interest rates will fade as reversion to the mean average ultimately becomes reality. Meantime, in the search for yield and a refuge from stock market volatility, investors have poured money into total market bond funds.

What are the risks? One leading total bond market index fund recently sported a 5.6 year duration. In simple terms, if interest rates went up by 1% (100 basis points) the fund could decline in value by 5.6%. Conversely, if rates fell by 1%, the fund could gain 5.6% in value. It is easy to see why bond funds have attracted so much money as interest rates fell over the last several years.

What trend do you wish to bet on—interest rates steady ad infinitum, down, or up? “Up” is the better bet and an open-end bond mutual fund may be the worst place to be. Investors with sufficient capital to meet money manager minimums for a separately managed bond account (usually $100,000 or more) are moving funds. Such accounts, where you own actual bonds in your name and not fund shares, are not subject to distortions from investor inflows and outflows.

A large percentage of bond fund holdings are inside of retirement plans and money can be moved in a blink with no tax implications. Negative returns could cause a stampede out of bond funds. Dodd-Frank reforms compel large investment banks to match bond buyers with sellers, increasing the spread between bid and ask prices. Bond managers can find attractive pricing when investors force fund managers to dump bonds. Conversely, in a separately managed account no one can jump into your “bucket” and force liquidation of a holding. Even if the market price has declined, the manager can manage the bond back to par, avoiding a loss.

For higher tax bracket investors, separately managed tax-free municipal bonds are attractive, offering advantages over their fully taxable counterparts. Such accounts could serve as a secondary low volatility emergency reserve for personal taxable money, a source of liquidity outside of the more volatile stock market.

Bonds are not risk free, and risks increase in rising interest rate scenarios. Do you have a strategy?

Lewis Walker is President of Walker Capital Management, LLC. Certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with Walker Capital Management, LLC. lewisw@theinvestmentcoach.com

2m3^