Last week’s Wall Street Journal reported that U.S. banks were now scrambling to shift their bond holdings into a category of bonds labeled as being “held to maturity.” Meanwhile, there’s an object lesson here for “little people” like you and me that recalls Cuba Gooding’s chant in the movie “Jerry McGuire --- “Show me the Money!”
Basically, what the banks are telling government regulators is that a growing portion of the bond values needed to meet new government-mandated reserve requirements are being set aside with the obligation to hold them to maturity. This means that if market interest rates rise because of, for instance, a move by the Federal Reserve to raise interest rates, the temporary falling value of these bonds can just be ignored. Their value for reserve purposes will remain at their maturity value. Banks now won’t have to scramble to make up the difference by, for example, cutting salaries and bonuses for top management or selling new shares to the public.
A quick reminder of how bond values fluctuate based on changes in interest rates is in order here. First, a bond that pays a specific interest rate for a fixed number of years, and then the bond reaches maturity and the original face value is paid back to the bond holder. However, bonds, like the one just described, are valued every day based on how they compare with a brand new bond that may pay higher or lower interest rates. Like a rope on a pulley, if market interest rates rise, the current bond paying the old rate will fall temporarily in value to compete with the new bonds paying the new higher interest --- and vice versa. As the bond approaches maturity, the point at which it all ends anyway, previous fluctuations in value slowly fade away and the bond is redeemed for its original face value.
“Everyone” expects interest rates to rise sooner or later. So far “Everyone” has been wrong starting with the Wall Street Journal in their 2008 editorial in which they predicted impending doom thanks to spiking interest rates caused by the government’s bond purchases. So much for self-styled interest rate soothsayers.
That’s not to say that it won’t happen one of these days. The banks recognize that the bonds they like to trade are the same ones that could be vulnerable to what could be a spike in interest rates and they don’t want the government all over them like a wet suit to raise money from some other means to meet the new higher reserve requirements. Banks can’t be leveraged like they were before. Investment banks, as an extreme example pre-crash, could be leveraged thirty to one. If they lost three percent, their equity was wiped out which is exactly what happened to Lehman Brothers and Bear Stearns.
By promising to earmark some bonds as ones that will be held to maturity, banks can make the case that the value of those assets will be whatever their current face value happens to be --- regardless of what the market may value them at in the meantime. Fair enough. Bonds like stocks are valued every single minute but the value at maturity never changes.
For individual investors, especially those in retirement, can adopt the same methodology --- or mentality to choose a better term. If market interest rates spike, it should only be a concern for someone who was under pressure to show that they were worth a specific amount of money at a given time. Banks for obvious reasons have to comply, but college endowments and pension funds fit into this category when they are under pressure to show the best possible short term results on an annual basis.
So, all the publicity surrounding the collapse of bond prices in the event of rising interest rates is immaterial for those retired people living on a fixed income from bond mutual funds. If market rates start rising, fund capital values will drop but interest payments deposited into retirees checking accounts will slowly begin to rise as old bonds in the fund are replaced by new ones --- every day. As frosting on the cake, a rise in interest rates will open a window of opportunity to move into bond funds at cheaper prices for those who haven’t done so yet. At that point, we can imagine Cuba Gooding, a retired football player, shouting, “Show me the bond funds!”