CIS
Model
Portfolio for
Income
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Two Enemies
Income investors have two major enemies.
The first is inflation and the second is rising interest rates.
Inflation devalues the
income received as it marches forward. A 10 year bond pays a fixed
amount of interest each year. But inflation keeps rising, so the income
received in the first year may only buy one half of the goods and
services it will in the tenth year, due to inflation and prices rising.
Rising interest rates
can depress an investment portfolio focused on income. Interest rates
and bond prices have an inverse relationship. As one rises, the other
declines. (This applies to pricing of bonds on the secondary market.
If held to maturity, most bonds mature at face value.) Here’s how
it works:
A hypothetical example
of this would be if you were to buy a bond for $10,000 due in 20 years.
It has a 5% coupon rate. But a couple of years later, rates climb
to 7%. Wanting the higher rate, you plan to sell your bond and buy
the higher rate bonds. But you can’t. Your bond is no longer worth
$10,000. It is worth about $8,100 on the secondary market.
This is because of Yield
to Maturity (YTM).
Current interest rates
force all other bond sectors into a relative equilibrium between price
and current yield. (Equilibrium is based on ratings, duration, etc,
described later in this report.) If rates have gone up, bond prices
come down. If rates go down, bond prices rise.
This is because of the
way the market works. Why would anyone pay full price for a bond yielding
5% when current new bonds yield 7%? So in order to entice buyers,
sellers have to drop the price for the bond until it hits an equilibrium
price, the YTM.
Conversely, if a seller
has a bond yielding 7% when the prevailing rate for similar bonds
is 5%, he can demand a premium, or higher price for his bond.
With interest rates having
been declining for almost 30 years, now lower than they were 50 years
ago, what direction should investors expect rates to go? Is it logical
to assume rates will go lower, or is the next major move higher?
Our research shows rates
should start to head higher in the coming years, much higher.
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