In the investment community, there has been a lot of handwringing over whether the markets can handle an increase in interest rates. There is a sort of blanket belief that rising rates are bad for investors. After all, Finance 101 teaches us that the higher the interest rate, the lower the present value of a future cash flow.
The investors who are hurt as rates rise include holders of long-term investments that pay fixed rates of interest—investors in long-term bonds and fixed-rate annuities. Market dislocations can occur when interest rates rise too quickly, like the bond market distress caused by the 10-year Treasury bond’s climb from below 1.7 percent in May to nearly 3 percent. It is also undesirable when interest rates are rising due to increased inflation, which distorts the value of assets and liabilities.
However, as my daughter is learning in her macro-economics class, some market constituents benefit from higher rates. For example, payers of fixed cash flows—the consumer who locked in a loan at a lower fixed-rate, companies that issued bonds at lower rates and insurers that pay annuitants fixed rates.
Pension plans also benefit from higher interest rates. The “Moving Ahead for Progress in the 21st Century Act,” which went into effect in July 2012, allowed pension funds to raise their discount rate—the rate used to determine the present value of the future liabilities they must pay. The law provided that pensions could use a long-term average of interest rates in their accounting calculations instead of the artificially low interest rates that prevail today.
U.S. Steel’s CEO told shareholders at its annual meeting that a 1 percent increase in interest rates would reduce the company’s $11.3 billion pension obligation by about $1.4 billion. The actuarial and consulting firm Milliman reports that over the past 12 months, the funded status of the 100 largest corporate pension plans has improved by $351 billion, a remarkable 17.4 percent, with much of the improvement due to the effect higher rates have in reducing liabilities.
Other beneficiaries of higher interest rates include those who receive cash flows from variable interest rate—such as savers in bank savings accounts and money market funds, as well as banks that receive interest from variable rate loans. Operators of money market funds like Charles Schwab, Fidelity, and Federated Investors will earn higher fees on money market funds as rates rise.
A well-managed bank actually can benefit from a measured rise in interest rates. As lower interest rate loans are paid off, new loans are made at higher rates. As long as the short-term rates that fund bank loans remain low, banks can earn more money from a higher “spread”—the difference between their cost of funding to make loans and the interest they earn on those loans.
While rising interest rates can serve as a headwind for stock market investors, the real effect depends on the how and why rates are increasing. A slow, measured increase due to an improving economy allows market participants and businesses the opportunity to adjust to effects of higher rates. This is the scenario the Federal Reserve is counting on to extract from its quantitative easing program and thereby allow rates to increase to a more normalized equilibrium.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or [email protected]