Rates' rise calls for closer look at bonds

Worth considering in planning retirement, financial experts suggest

Your Money

May 23, 2004|By Tom Petruno

Popular wisdom says rising interest rates are bad all around. But, for many Americans, higher rates aren't an enemy. They're a friend.

The interest return on long-term U.S. Treasury bonds is the highest in 22 months. That ought to get the attention of investors who are sitting with large sums in cash accounts that earn next to nothing.

Rates on corporate and municipal bonds also have jumped this year. The upshot, say financial advisers, is that people wondering how they are going to fund their retirement ought to consider what longer-term bonds can offer in interest earnings and principal preservation.

Popular wisdom might be stopping investors from giving bonds a look. Everyone knows the Federal Reserve is expected to begin tightening credit this year, possibly as soon as next month. Shouldn't you wait for the Fed to formally raise interest rates before thinking about bonds? That's a common misconception, says Richard Lehmann, publisher of the Forbes/Lehmann Income Securities Investor newsletter in Miami Lakes, Fla. (www.incomesecurities.com).

The Fed controls short-term interest rates by its influence over the federal funds rate, the overnight lending rate among banks. The Fed has held that rate at a 46-year low of 1 percent since June. But the central bank doesn't directly control longer-term rates, such as what bonds pay. Those rates are determined by the actions of investors in the market.

When the economy is strong, as it is now, and investors perceive that the Fed will soon be raising short-term interest rates, bond yields tend to shoot up well before the central bank moves. Likewise, long-term yields tend to begin dropping well before the Fed begins to ease credit. Indeed, four years ago this month, 30-year Treasury bond yields were below yields on two-year T-notes. Investors had begun to anticipate that the Fed would start lowering rates (the central bank's cuts began in January 2001).

The big question is how high all interest rates might go before they top out. Nobody would lock in a fixed annual rate of, say, 5 percent on a long-term bond today if they knew they could lock in 7 percent a year from now.

A glance at a chart of bond yields since 1999 shows that current rates, although up sharply from their lows last year, remain well below the highs of 2000.

The annualized yield on the 10-year Treasury note has surged from a low of 3.11 percent last June to 4.77 percent. But the T-note yield peaked at 6.79 percent in 2000. Could rates get close to that level again? There's no way to know.

Many related factors determine interest rates at any given moment. The Fed's rate stance is one factor. The health of the economy is another. Inflation expectations also are key, because inflation erodes investment returns. If investors believe that inflation will rise substantially, they'll demand higher bond yields to compensate.

A pickup in inflation has contributed to the rise in bond yields this year. Consumer prices rose at an annualized rate of 4.4 percent in the first four months of the year, up from 1.9 percent for all of 2003. Higher energy prices have been a major culprit. Many economists believe that full-year inflation this year will be between 2 percent and 3 percent. Longer-term inflation expectations also are in that range.

If those estimates are on target, it's possible that long-term interest rates have further to rise. That's one reason financial advisers generally aren't telling clients to rush into bonds. But people should at least begin nibbling, many advisers say.

Tom Petruno is a columnist for the Los Angeles Times, a Tribune Publishing newspaper.

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