Interest Rate Hike Offers Good News, Bad News

To generate an annual income of $100,000 from a super safe 10-year U.S. Treasury bond in 1981 -- when the interest rate hit an all-time high of 14.59 percent -- you needed $680,000 in savings.

In 2000, you would have needed $1.5 million to generate the same $100,000 in risk-free income.

By last month, you needed $4.5 million.

One of the unintended consequences of the Federal Reserve Bank keeping interest rates so low for so long is that conservative investments such as savings accounts, bank CDs and Treasury bonds have fallen woefully short of rewarding savers with a decent income as the key federal funds interest rate hovers near an all-time low of between 0.25 and 0.50 percent.

That could be changing if interest rates begin marching higher. The Federal Reserve raised rates by 0.25 percent in December last year for the first time since 2006. Further rate hikes were put on hold due to concerns about the jobs picture. But the economy has shown signs of improvement in recent months, and the case for higher rates has gained traction among its board of governors.

Unless the bottom drops out of financial markets between now and the next meeting of the Federal Reserve on Dec. 13-14, the nation's central bank is widely expected to raise short-term interest rates. The federal funds futures market, which signals potential price moves in interest rates, is predicting a better-than-90-percent probability that the Fed will raise rates when it meets next week.

"Rising rates are good for savers, on the positive side. But rising rates will cause a rise in the monthly payments of variable rate consumer loans, including mortgages and credit cards," said Robert Hapanowicz, president of Hapanowicz and Associates Financial Services, Downtown. "Fixed rate loans will remain the same, but if you have a variable or adjustable rate loan, you can expect your payments to rise."

Higher interest rates also could spell trouble for workers with defined benefit pension plans, he said. These plans generally offer an annuity that is structured around the participant's age, years of service and compensation.

"Some pension plans also offer a lump sum feature, which is essentially the present value of all the future monthly payments discounted to reflect current interest rates," Mr. Hapanowicz said. "As interest rates rise, pension lump sum payments offered to retiring employees get smaller."

Mr. Hapanowicz said many of his clients are employees of companies that offer pensions and he has had to explain to them that when interest rates move higher, the present value of their pension moves lower. He said a 1 percent change in the interest rate could affect their cash out by 10 percent to 12 percent, which means a $1 million pension lump sum could get knocked down to roughly $880,000 to $900,000.

With rates near historic lows but heading higher, he said those near retirement should consider whether it would be smart to take a lump sum versus an annuity.

Many financial industry players are predicting the Fed's rate hikes will come gradually, probably 0.25 basis points each time.

Bond fund investors also could be vulnerable to losses in a rising interest rate scenario. Interest rates and bond prices have an inverse relationship. When rates rise, bond prices fall -- and vice versa. That means a portfolio of bonds or bond funds will likely decline in value when rates go up.

Bonds are a form of debt that is issued by government entities and corporations to raise money from the public. Investors who buy bonds are lending money to the issuer of the bond. The bond issuer promises to pay a specified rate of interest to the investor during the life of an individual bond and repay the bond's full face value when it matures.

Bond mutual funds, on the other hand, don't have a set maturity date because fund managers pool money from many investors, often buying bonds and selling bonds in the fund before the bonds mature. The value of a bond fund may vary from day to day due to fluctuations in interest rates. Bond funds also are under no obligation to return an investor's principal.

"For those investors who have tried to stick out their conservative nature by remaining in bond mutual funds, a raise in interest rates could be the beginning of Armageddon," said Curt Knotick, owner of Accurate Solutions Group in Butler. "When interest rates rise, bond values fall, and they fall quicker than many of us could imagine."

An emotional response could be triggered by a drop in value, Mr. Knotick said.

"When the Federal Reserve begins to raise these rates, will there be a 'run on the bank', so to speak? Everyone trying to get out of the bond mutual funds and, if so, that could truly exacerbate the situation. Those investors who thought they were taking less risk on a bond fund versus stock funds may be in for a real shock."

The fallout from a rate increase might not be as damaging to bond investors as many are imagining, said Mark Luschini, chief investment strategist for Philadelphia-based Janney Montgomery Scott, which has $70 billion in assets under management.

"The rate hike is near certain," he said, "but the likelihood is that the hike is already factored into current bond prices. Although there will be a slight adjustment as a consequence of the bump in short-term interest rates, the impact should be relatively small because we are starting from such a low base."

Although a rate hike this month will be only the second in several years, it isn't entirely unwelcome, he said.

"A rate increase will be good eventually overall if done in the context of strengthening economic conditions, and the Fed seems sufficiently comfortable with the notion that the economy can stand higher rates," Mr. Luschini said.

"If the economy continues to improve, the Fed could go on a more aggressive rate hike campaign, and that could be harmful to bonds and bond funds."

Tim Grant: [email protected].

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