July 16, 2019Individual Investment Management

Recently I was visiting with a prospective client discussing her portfolio.  As we began to discuss the allocations, I spoke briefly about her large bond position relative to her goals and how moves in interest rates may affect her.  I was then presented with a simple (and not unreasonable) question - "Why do you guys obsess over interest rates so much?!"  

So why DO we obsess over rates?
Money is like any other product - it has a network of distribution and mark-ups. Example:  If you buy a shirt at a favorite retailer, the retailer acquired that shirt from a wholesaler, who acquired it from a manufacturer.  Each participant in the chain has marked that shirt up to the next participant enough to (ideally) ensure a profit for the owners, as well as remain competitive in the marketplace.  Money is no different!  

When you acquire a loan, that loan originator "bought" that money from a large bank or institution who had in turn "bought" that money by borrowing directly from the Federal Reserve or by borrowing it from some other large participant in the marketplace - but the effect is the same.  So....why do interest rates matter???
Note:  Interesting read on this here.

Cost drives everything.
A wise man once said, "You don't make your money on the sale, you make it on the buy."  This statement is a nod to the reality that the cost of what we buy drives everything because it is cheaper to use other people's money than your own - your own money has a higher required rate of return.  Thus, businesses are always borrowing to invest to remain competitive and properly leverage their resources.  A bank that is forced to pay a higher rate on its money MUST in turn charge more for a loan to Joe Q. Public.  Joe must then spend more on his loan which means he has less to spend on everything else!  Simply put, interest rates are the purest expression of the cost of money - which in turn drives the cost of everything!

The rate multiplier effect.
Even small changes in the underlying rate of borrowing have "multiplier" effects through the economy.  A 1% rise in mortgage rate on a $160,000 mortgage will raise your monthly payment by $100, thus translating to over $30,000 of additional lifetime loan costs.  (Not taking into account taxes.)  A 2% rise in rates on a typical investment-grade bond fund can often result in a 15% loss in value on that investment (bonds fall when rates rise, all else being equal).  This is referred to as "interest rate risk" by the financial community.  This risk is the reason why professional advisers and the financial industry watch interest rates much more closely than they watch the stock market.