From the General's Desk

The contents herein are for informational purposes only, and under no circumstances are they to be construed as a recommendation of a solicitation. The information and opinions herein are subject to change without notice and CFI does not undertake to advise the reader of changes in opinion or information.

March 31, 2015


Market expectations have caused a recent flattening of the yield curve. This is due to the near term apprehension that the Federal Reserve will commence raising short term rates and the belief that their action will have little or no effect on longer rates. The prevailing forecast, that the Fed will act sometime between June and September of this year, may have been discredited by the most recent data, however, as it seems to indicate a loss of economic momentum. If one focuses on the labor participation rate, wage growth, and the absence of inflationary pressures, not to mention the global picture, it’s hard to see our “data-dependent” Fed pulling the trigger anytime soon. The fear of higher interest rates persists, however, and that is the subject I would like to discuss.


Anticipating higher rates, at least on the shorter end of the curve, is quite rational. Fearing that event is not rational. Obviously those investors who have dramatically under-performed by staying far too short or far too long in cash and cash equivalents will have some relief available to them, assuming they don’t get greedy (more on that in a moment). Higher rates can be a real opportunity for those with portfolios of normal maturity distributions. In CFI’s case, the typical  discretionary account’s average probable life is between four and seven years.


Let’s take a simple illustration. Suppose interest rates rise and, as a result, the market value of your portfolio declines. The value of some items fall below your cost yield. This results in a book loss on those items. If any of them are sold under those conditions, an actual loss will occur. Consider that the loss will occur because interest rates are higher now than when you bought the bonds originally. Why not exchange the lower yielding position with a higher yielding one? The answer is that you should, provided you have done the math first. Calculate the amount of the potential loss first. Next, calculate how much more money the replacement bonds will return each month over the sale candidate. Be sure when calculating that you only use the principal proceeds generated by the sale and you adjust for any amortization. If the new bonds earn $100 more per month and the loss the sale produced was $1,000, your breakeven period is ten months. If you do the swap, in ten months you will have recovered all of your loss. Each month thereafter, you are $100 better off.

This tactic has other potential benefits. Besides increasing the portfolio’s yield, you may improve credit strength. Maturity distribution and call protection could possibly be improved as well. Establishing an actual capital loss can neutralize the tax liability of a like amount of capital gain. As capital losses can be carried forward indefinitely, you can play this card anytime in the future if it isn’t needed now.


The skeptic may advise waiting in hope of even higher yields. My advice is to do the swap. If higher yields actually arrive, repeat the swap with another, and another, if you can. Remember our objective is to both recover losses as quickly as possible and to acquire the highest possible average weighted cost yield consistent with each client’s credit and maturity risk parameters.


Let’s get back to our guy who was “greedy.” In reality, he is trying to time the peak in interest rates. This is a fool’s errand. There are countless independent variables that make accurate, finite predictions impossible (hence, the trader’s adage “ . . . better to be lucky than smart”). If after climbing, interest rates for any of a host of reasons, decline again, “greedy” will have accomplished nothing. If the preponderance of evidence says it’s a good time to swap and you have losses you can take, get to work. Making a significant shift in a portfolio of U.S. Treasury securities, or stocks for that matter, can be accomplished very rapidly. After all, there is a ready bid for what you’re selling and what you wish to acquire is readily available in any quantity you desire. This isn’t so with municipal bonds. Swapping well is both labor and time intensive. Converting a substantial portion of your portfolio could take weeks to do it well.


Higher interest rates, especially in the absence of higher inflation, are most welcome and not to be feared. A word of caution, however: selling short, high-grade bonds and buying long junk may look great and make up a loss in no time, but your new purchase could come back to haunt you. Stay within your original parameters and you’ll be fine.


Author: Charles W. Fish, Chairman



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Charles Fish Investments, Inc. (CFI) founded in 1984, is a Registered Investment Advisor with the Securities and Exchange Commission under the Investment Act of 1940 and notice filed with the California Department of Business Oversight. The firm, which is wholly-owned by its employees, is not affiliated with any broker/dealer. CFI's revenues are derived exclusively from the fees received for the investment advisory and/or management services provided.


ADV Part 2 A