Are interest rates being held artificially low?

Currently the feds have elected to flood the market with additional funds for mortgages and in particular for refinancing current mortgages. Rates are as low as 4.5%.

But how long can this last?

Let’s look at the junk bond market as a potential indicator of what could happen.

First off what makes a bond a “junk” bond? Think of it as a risk reward proposition. If I were to offer you a very safe, stable, predictable bond with little to no risk, I would be able to offer this bond at a very low rate because the probability of this bond being paid out at maturity is very high. On the other hand if I offer you a more risky bond that has the probability of defaulting, in order to attract you to purchase such a bond I will have to offer you a higher rate for you to accept the risk. Simply put the higher the risk the higher the reward should be.

As our government continues to print money without any real backing and as we auction off more and more debt through the treasury department. The time may soon come when those who are investing in our government bonds will demand a higher rate for those bonds as the probability of default looms ever higher. In other words we are printing money and debt that we simply cannot pay back with our current budget and taxes. Something will have to give at some point.

China is one of the largest purchasers of our debt. As they see our inability to repay these debts increase they will likely demand a more attractive interest rate to continue purchasing our debt. The US Treasury Bonds could soon become a “junk bond” in the investment world. The result could be dramatic. In all probability we would have to increase interest rates to attract new buyers or to keep current buyers investing at maturity.

If this scenario plays out you can be assured that all interest rates will rise. How high? Who knows. But remember we did this once before in the late 70’s and early 80’s. You may want to assess your portfolio and determine how much interest rate risk you are actually taking, maybe even unknowingly.

Remember the general rule; bond values decrease as interest rates increase and vice versa. The longer the duration of the bond the more widely the fluctuation can be. Although the interest rate remains the same, the underlying “market value” of the bond can fluctuate until the bond matures at face value.

For example. Let’s assume I purchase a 20 year bond for $1,000 (par value) today and the interest rate is 4%. Now let’s fast forward 2-3 years and interest rates have climbed to 7%. Now a bond buyer could purchase a $1,000 bond (par value) and get 7%.  For my valuation purposes a calculation is made which discounts my $1,000 bond in order to equal the current 7% rates. I won’t go into that yield calculation here, but suffice it to say in order for me to attract someone to buy my 4% bond, when they can buy a 7% bond today, I will have to discount my $1,000 par value in order for them to essentially achieve the same return as they would by buying the 7% bond today.

If interest rates are being held artificially low, and if the chance of interest rate hikes are on the horizon, what are your options?