On Sunday, March 16, the Federal Reserve Bank (the Fed) took aggressive measures to lower the effects of the Coronavirus-19 on the United States and Global Economies. They lowered the Fed Funds rate from 1% to 0%. This follows the rate cut made 2 weeks prior on March 3 from 1.50% to 1%. The last time the Fed took such aggressive actions to cut interest rates was back in 2008, during the Great Financial Crisis.
Since 2008, the United States and other global economies have maintained historically low interest rates to offset the effects of deflation and to increase economic activity. Some countries, like Japan, Eurozone, Switzerland and others, have flirted with negative short- and long-term interest rates.
Fed funds rate is the anchor for banks and financial institutions to determine longer term interest rates, to create what is known as the yield curve. A lower fed funds rate will allow banks to lower interest rates on mortgages, home equity loans, credit cards, business loans, and other lending activities. Alternatively, the 0% interest rate environment is hurting people with cash, savings, and investments. To put in perspective where we are today, in the 1980s the fed funds rate reached 19.1% and 6-month CD rates hit 17.75% (Federal Reserve).
The average US Treasury 10-year bond rate during the 1980s was 10.59%. Currently, the 10-year US Treasury bond is yielding 1.05%. If you had retired in the 1980s vs. in 2020, your investment income would be around $95,400 higher each year.
The low interest environment is creating challenges for many who are retiring or who are already retired. To maintain sufficient income throughout retirement, many are faced with the challenge of staying invested in the stock market or investing in low yielding bond funds in the uncertain economic environment. In an attempt to reduce the investment risk of stocks, many investors are turning to bond funds with lower credit quality (high yield bond funds) and/or longer maturity for higher yields, without the understanding the true risks.
Investors purchasing high yield bonds take on significantly higher credit risk vs. interest rate risk. In the lower trending interest rate environment we are experiencing currently due to the Coronavirus-19, at the time of writing, the iShares iBoxx USD High Yield Corporate Bond ETF (YTD down 12.42%) has underperformed the iShares 3-7 Year Treasury Bond ETF (YTD up 4.45%) by nearly 16.87% since the beginning of the year.
If the events of 2008 are any guide, we can expect the Fed to aggressively utilize all the tools at its disposal to stabilize the financial markets and avoid a prolonged recession. It is likely that interest rates will stay low longer than most expect, as the Fed waits for the economy to find footing and exhibit a sustainable path of growth. Similar to 2008, today’s uncertainty will likely present opportunities and challenges for borrowers, lenders, and investors going forward.
Steve Kim is a Managing Director at Brady Associates Asset Management and has an office in Greenfield, MA.
For more information, see the following:
https://www.depositaccounts.com/blog/historical-cd-rates.html https://www.forbes.com/sites/forbesfinancecouncil/2019/09/03/retirement-trends-of-babyboomers/#5b3f56457378 https://www.thebalance.com/the-basics-of-investing-in-high-yield-bonds-417068 https://www.barrons.com/articles/bbb-rated-bonds-high-yield-debt-dividends-51570049607
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