Interest rate hike is no reason to panic

Real Estate Weekly, June 30, 2004

Investors worried about new volatility in bonds, real estate and stocks due to rising interest rates need to keep cool if they are going to avoid making costly mistakes, according to a warning issued recently by three investment advisors from across the United States.

The trio of experts outlined five things skittish investors should keep in mind about bonds and real estate as interest rates start edging up.

The financial advisors BHCO Capital Management managing director Steve Lugar, Plancorp president Jeff Buckner and Savant Capital Management managing director Brent Brodeski--are all members of the Zero Alpha Group. ZAG is a nationwide network of eight fee-only investment advisory firms that manage over $3 billion in assets.

In their recent news conference, Lugar, Buckner and Brodeski focused on the following five points:

1. Investors should stay away from long-term bonds. Most individual investors have no real use for long-term bonds. They are more appropriate for certain institutional investors and those looking to speculate.

In a period of rising interest rates, most individuals should work with their financial advisor to find bond-based mutual funds that include shorter-term U.S. government bonds, high quality corporate bonds, global corporate and government bonds and possibly municipal bonds. The appropriateness of these bonds is determined in large part based on an investor's tax situation.

2. Investors should watch out for the bursting of the real-estate "bubble." Home mortgage rates may cause a challenge as interest rates start moving back up.

"The real estate market has done really well over the past five years," said Brodeski. "This sector may very well lose its luster as interest rates rise. Because the market has been so hot, a noticeable rise in short-term rates could cause the bubble to burst as real estate becomes less affordable and thus, less appealing.

Practical investors should work with their financial advisor to determine a reasonable allocation to real estate within their overall portfolio. This way, the consequences of a 'bubble burst' will not greatly affect their long-term financial plan and financial security.

Otherwise, an increasing number of real estate speculators might get an unpleasant wake-up call."

3. Investors should avoid thinking that bonds are always safe. In many cases, bonds can be used to diversify risk in a long-term portfolio. However, investors still need to understand that bonds are not risk free and should not be viewed as being the equivalent certificates of deposit or cash. Their principal does indeed fluctuate, dependent on interest rates.

According to Lugar, "Bonds serve an important role by complimenting equities--not replacing them. They reduce overall portfolio volatility. Secondly, bonds are instrumental in generating higher cash flow for investors than what historically has been provided by stocks.

Over the long-term, the cash flow from bonds will increase as rates rise, helping to mitigate the short-term drop in bond prices when rates move upward."

4. Farewell to ARMs? Over the last several years, homebuyers have refinanced their mortgages at historically low interest rates. At this point, it may be prudent for them to evaluate fixed-rate mortgages, as opposed to seeing their payments steadily ratchet up under adjustable rate mortgages (ARMs). The number of homebuyers using ARMs increased to 35% from 14% just one year ago.

As short-term rates move upward, those who hold ARMs will take on the risk of steadily escalating mortgage payments. By historic standards, fixed-rate mortgages are still incredibly low--representing a real bargain for prudent investors who want to avoid getting stuck on the ARMs rate treadmill.

5. Investors shouldn't assume that long- and intermediate-term rates will increase. Most people just take it for granted that intermediate- and long-term interest rates will increase and cause bond prices to drop as the Federal Reserve increases short-term rates. This is far from certain and making investment decisions on this flawed premise is unwise.

While investors assume rates have approached all-time lows, they may actually be higher than average when compared to the very long-term numbers. As of May 31, 2004, the 20-year Treasury yielded 5.4%--higher than the 4.8% long-term average Treasury return from 1900-2000. With inflation now also being lower than average (2.95% for the roiling twelve months ending May 31, 2004 vs. the 3.2% long-term average between 1900 and 2000), the current real long-term interest rates of 2.45% are actually higher than their 1.6% long-term average between 1900 and 2000.

The ZAG members also advised investors to keep in mind that interest rate adjustments are a good thing in the long run.

"It is vitally important for investors to realize that the Fed controls interest rates to keep the economy from falling out of check in either direction," said Buckner. "Small fluctuations in interest rates keep inflation from going haywire."