Fed perhaps raising rates a notch in the second half, most likely in the final quarter of the year, probably 25, 50 basis points (bond industry jargon for .25%-.50%). Overall, that’s nothing to cause any major disruptions for the stock market.
Inflation, which often pushes the Fed to act, has been at a tame 2%-3% level for most of the last decade or so. One sign that it’s benign is the fact that the Treasury introduced inflation indexed bonds, called TIPS–Treasury Inflation Protection Securities–which in the current environment are generating a lot of interest.
As fixed-income investors, how should you react to the current climate?
HUGHES: In our business, we look at the yield curve, which plots the difference between interest rates on bonds maturing two, three, five, 10, on out to 30 years from now. Today, the yield curve is pretty flat. That means the difference in interest paid by a two-year bond and a bond maturing in 30 years is about half a percent. Big deal! Remember, moving to a maturity that far off in the future, you incur higher risk. So for most folks, we say unless you have some definable target that you are investing for, don’t opt for bonds maturing much past five years. Basically, at five years you get 6%. That’s still a good deal compared to a bank CD. You pick up 50 or 60 basis points–that’s five-tenths to six-tenths of a percent. That seems like a little, but when you’re talking about 5% interest, that’s an extra 10%. The other thing is that essentially you are trading up in quality when you choose Treasuries over a bank CD.
I’d advise readers to look at the long end of the bond market–10-year maturities or greater–only if you have a long-term goal, say a kid’s tuition to pay in about 10 years. A long-term holding paying 7% looks good for that kind of goal. The TRIPS or inflation protected bonds might make sense under that scenario too. The bonds guarantee 3.5%, and if inflation stays in the neighborhood of 2.5%-3% an
nually, you’ll get pretty much the same rate as a regular Treasury with a bit of insurance as well.
So how about stocks? Are there any good trends to key into?
CARTER: We like banks and financial institutions. They have traditionally had P/E ratios that were lower than the market average, but now they are moving up to higher levels. That’s because their earnings growth is starting to advance and there is really no concern of any major pull back.
BE: You’re not worried that high levels of consumer debt might hit a Citibank or Chase Manhattan that has an extremely large credit card business?
CARTER: It’s already hit in the first quarter or early in the second quarter. These days, though, banks can refigure things very quickly. Their profitability is very good, and they can set aside money for those anticipated losses and then tighten up their credit standards very quickly.
HUGHES: A lot of credit card debt doesn’t ride on