Interest rate hike and its effect on bonds

3 x 2  World B. Free
Former 76ers player World B. Free speaks at a Wells Fargo Center event for Philadelphia schoolchildren. Free has been critical of the Federal Reserve's refusal to raise interest rates.

To paraphrase a line from The Hunger Games, may the odds be in our favor that the Federal Reserve raises interest rates this month.

Savers want the Fed to make the move. The measly interest on savings accounts and yields on Treasury bonds needs to normalize, particularly for retirees who live on fixed incomes and pensions.

For bond investors, a rate hike is more complicated. Though the Fed's long-anticipated reversal signals that the economy is improving, higher rates can roil bond prices. Don't be surprised if your bond portfolio bounces around.

How are local portfolio managers playing the move?

By lifting rates from zero, the Fed finally shores up its credibility, says Chartwell Investment Partners' Andy Toburen, senior portfolio manager in fixed income for the Berwyn investment firm.

"The Fed has been telegraphing a rate hike for months. So the most important thing is the change in direction, not the magnitude of the expected hike" of 25 basis points, or 0.25 percent, Toburen said.

To illustrate how rate hikes affect bonds, let's say short-term rates rise from zero to 0.50 percent. The price of a two-year Treasury might fall from $99.28 to $98.78; a five-year bond could drop from $99.20 to $97.07.

Among long-term bonds, a 50-basis-point change means the 10-year Treasury, currently trading at $99.26, might fall to $95.67. A 30-year Treasury trading about $99 could fall to $90.76, a 10 percent drop in price.

Professional investors sometimes hedge bond portfolios against rate moves with exchange-traded funds such as ProShares UltraShort 7-10 Year Treasury ETF (PST), corresponding to twice the inverse (opposite) of a 7- to 10-year Treasury. When Treasury prices fall, it makes money. ProShares UltraShort 20+ Year Treasury (TBT) does the same thing, except on 20-year Treasuries.

These gain in value when Treasury bonds fall and interest rates rise.

David Kotok of Cumberland Advisors uses PST and TBT at times but warns they aren't suitable for the uninformed.

They also "don't track perfectly because the funds go to cash overnight, but that means there's no counterparty risk," Kotok says. "For clients who want to hedge their risk in bonds, we use these."

Jonathan Smith of DT Investment Partners, in Chadds Ford, does not use these ETFs. Instead, he and his partners select individual bond holdings.

"Many of these ETFs are engineered using synthetic options and don't move appropriately," he says. "They get hurt when rates go down, or, when rates go up, the funds don't seem to participate to the same degree commensurately."

The Fed's problem, Smith notes, is not the coming rate hike, but when to do the next one.

"No one believes inflation's going to be a problem over the next few years. But the Fed has to raise rates because it's been so long since they have."

Interest rates are on everyone's mind these days - even former professional athletes.

World B. Free, 76ers basketball legend, is frustrated about them. A self-taught investor, Free put his career winnings into investments in equities and real estate.

Asked what he thought about Fed Chair Janet Yellen's decision not to raise rates last time around, he says: "It's stupid. The current situation, with the end of the recession, the housing recovery, and inflation, aren't reflected in the level of interest rates today."

Last week, Free and actor/author Hill Harper led a financial-education seminar for more than 2,000 middle-school students at the Wells Fargo Center.

Local seminar

The Philadelphia chapter of BetterInvesting, a nonprofit investment club, will host a full-day seminar Saturday at the Community Center at the Super Giant store, 315 York Rd., Willow Grove.

If you want to learn which retirement plans to choose, how to get started investing, and tax consequences, consider attending. The cost is $15 and includes lunch, whether you are a BetterInvesting member or just thinking of joining.

To register, contact Gloria Mankonen by calling 215-796-1214 or emailing contact@philly.betterinvesting.net.

earvedlund@phillynews.com

215-854-2808@erinarvedlund