Bond Investors Beware: Mutual Fund Outflows Accelerating as Interest Rates Climb Higher

We all are quite aware that the economic recovery has been less than stellar. One area of serious concern—which I alerted my readers of months ago—is the upcoming rise in interest rates. 

This is not a new topic for my long-time readers; I began warning readers to get out of long-term bonds when I issued my forecast months ago that interest rates were set to rise, even if the Federal Reserve didn’t start hiking them up immediately. 

This is now starting to hit home, as outflows from U.S. mutual funds that specialize in bonds and exchange-traded funds (ETFs) that invest in securities tied to interest rates are increasing. According to TrimTabs, so far for the month of August, $19.7 billion has been pulled out of U.S. bond mutual funds and ETFs. That is already greater than the total for July, when $14.8 billion was pulled out of these investments. (Source: TrimTabs web site, August 19, 2013.) 

This is causing interest rates to continue rising, and all of this has occurred before the Federal Reserve has even begun adjusting its monetary policy. As I’ve stated many times, people are under-estimating the impact of the upcoming policy changes, and higher interest rates are here to stay.

Chart courtesy of www.StockCharts.com 

With 10-year interest rates now above 2.84%, I believe this will begin to have an impact on the economic recovery in several areas. 

Obviously, the economic recovery has been primarily driven by two sectors: automotives and housing. Both sectors are firing on all cylinders. Capacity utilization is through the roof for car factories, as car sales went from 10.4 million in the trough of 2009 to an annualized rate of 15.8 million for 2013. (Source: “America’s Car Factories,” Wall Street Journal, August 17, 2013.) 

The issue, if interest rates continue rising, is that this could start to reduce the positive growth in these industries, slowing the economic recovery. 

People are buying these large items through cheap mortgages and financing. If interest rates rise, the level of affordability is eroded; this could impact the economic recovery. 

Another problem that’s rarely mentioned is the cost of holding these bonds: as interest rates rise, the value of the bonds falls. The problem is that many banks hold onto these assets, which they have to adjust their value. The net result is that while bonds can enhance profits as the yield curve increases (they make the money between short-term and long-term interest rates), the book value of the bank remains neutral or could decline as the value of the bonds decreases. 

This could also have an impact on the economic recovery. A strong banking system is imperative to a healthy economy, as we know what can happen if the financial system is built on a weak foundation after seeing just that during the recent recession. 

The key takeaway point for you is to continue avoiding long-term interest rates—at least for now. Look at the chart; some people might think 2.84% is “high,” but even as recently as 2010, interest rates were up to almost four percent. We still have a long way to go, and we’ll have to see just how great an impact higher rates will have on the economic recovery. In either case, investing in long-term bonds still appears to be quite risky to me. 

~ by Sasha Cekerevac, BA

This article was originally published at Investment Contrarians