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I feel this outcome, while possible is not likely probable and furthermore rising interest rates is a potential future danger while there is a very real and prevalent danger today: sustained low rates.
Here are some of the ways low rates are a danger to bonds and bond funds:
- Low rates are an indication there is more demand by lenders to lend than there is demand by borrowers to borrow. In essence, the price (i.e. yield) of loans rises and falls as supply (lenders) and demand (borrowers) changes.
- Low rates are an indication lenders are both eager and willing to lend. When times are tough, the demand for the safety of cash increases and lenders tend to only lend to those with the strongest credit or highest collateral. As the economic outlook improves, the demand for the safety of cash falls typically in conjunction with the lowering of credit standards and collateral requirements.
- Low rates encourage investors to “chase yield” by either buying lower credit quality bonds or buying longer maturity bonds than they would normally buy.
- Low rates encourage traditional money market and CD buyers to buy bonds in an attempt to maintain the amount of interest they used to receive. These new bond buyers add more demand which pushes prices up and bond yields down.
- Low rates encourage companies to refinance their old bonds with newer, lower paying bonds. While this is a good financial move for the companies it’s bad for me as an investor as all I’ve seen lately is the interest from my corporate bond funds steadily declining as redemptions have increased.
- Low rates encourage home owners to refinance their old mortgages with new, lower paying mortgages. See above point except substitute GNMA/mortgage bond funds for corporate bond funds.
- Low rates encourage companies to change their qualifying standards for projects. If it costs a company 10% interest to finance a project than that project must be projected produce a profit of at least 10% plus a margin of safety in order to be “green lit”. By lowering the cost of borrowing, more and more borderline profitable projects may get the go ahead. Remember all those dot.com names that came and went. I wonder how many of those project would have been shelved or repositioned if people weren’t throwing money (i.e. offering extremely low interest rates) at them.
- Low rates mean I take the same level of risk (i.e. if the company that issued the bond goes out of business I’ll very likely lose money) but I am earning a much lower amount of interest while I am taking this risk.
- Low rates encourage borrowers such as students, home buyers, companies, etc. to borrow more than if rates were higher since their payments would remain about the same. I imagine the home bubble wouldn’t have been blown so big if interest rates were higher.
- Low rates require companies to pour more money into their pension plans. These are funds that could have been used to other purposes.
