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What Could a Fed Rate Hike Mean for Your Portfolio?
Tuesday, November 10th, 2015

As of late the Fed has been talking about a potential rate hike in December. Many are unsure what this means exactly, and are unaware of the potential effects it could have on the economy and their portfolio.

It is important to first understand what a rate hike means. When the Fed discusses a rate hike, it is related to them raising the target Feds Fund Rate, which is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.

This rate has been near zero (which is a historic low) since the Great Recession began in 2008. It can be viewed as the base rate for all other interest rates in the U.S. economy. This concept can be seen in the correlation between the Feds Fund Rate and the 10 year Treasury yield. The graph below shows that the Feds Fund Rate moves with the 10 year treasury yield. 

The main concept to be seen here is that as the Feds Fund Rate increases, the interest rates on bonds will increase. This is an important idea for bondholder’s to understand, because bond prices and interest rates have a negative correlation.

Simply put, when interest rates increase, bond prices decrease. The reason for this is that when new bonds with higher interest rates are issued, the demand for those older bonds with lower interest rates decrease which ultimately drives down the price for those older bonds.

There may be periods where there is an inverted yield curve. This means that short-term rates are higher than long-term rates. Even in periods of this nature, rising short-term rates drove up long-term interest rates.

This would not be the first time many investors lost money in bonds. In an article titled The Great Bond Massacre, author Al Ehrbar describes the losses due to an increase in interest rates.

"In January 1994, the 34th month of economic expansion, bond yields were historically low and inflation seemed negligible: Wages were going nowhere, and companies dared not raise prices. But within seven short months of that promising start, something fairly unusual happened: 1994 became the year of the worst bond market loss in history. Since the Federal Reserve began nudging short-term interest rates higher in early February, the bond market has inflicted heavy damage on financial companies, hedge funds, and bond mutual funds. Fortune estimates that the rise in 30-year Treasury rates from 6.2% at the start of the year to 7.75% in mid- September has knocked more than $600 billion off the value of U.S. bonds."

Many investors believe that bonds are a safe asset that doesn’t lose money, but unfortunately many people forget about the correlation between interest rates and bond prices.

A rise in interest rates will also have an effect on many large corporations. When interest rates increase, the cost of borrowing will increase. This means that before you invest in a stock you should do your homework and understand how they will be affected by an increase in rates.

Several factors to look out for when analyzing companies include: their current debt level, whether they’ve been paying off that debt or issuing new debt, their current ratio, and their current cash flow. Two companies that have red flags going into a period of rising interest rates include Verizon Communications (VZ) and Tesla Motors (TSLA).

Verizon currently has a debt-to-equity ratio of 854.96, which is more than double the industry average of 365.9. Their current ratio is 0.63, which is below the industry average of 0.83. This is concerning because if they do not have the current assets to pay off their current liabilities they may need to issue even more debt.

Their total current debt outstanding is $118,968,000,000. This is a major concern, as they had an interest expense last quarter of $1,386,000,000. This directly reduces the earnings of a company. If Verizon has to continue and increase that amount of debt in an environment of rising interest rates, you will continue to see that interest expense grow.

Tesla continues to issue new shares, issue more debt, and produce a negative cash flow. Year-to-date, Tesla has lost a total of $494,650,000 in cash from operating activities. Since they are not producing cash they continue to borrow money and issue more stock.

Year-to-date, Tesla has issued over $844,000,000 worth of new stock and has borrowed over $183,000,000 in long-term debt. By continuously issuing more stock they are making the current stockholders’ stake in the company less valuable.

With a negative cash flow, Tesla may have to continue to raise capital by issuing more debt and issuing more stock. Increasing their debt levels in a period of rising interest rates will increase their interest expense and make Tesla lose even more in earnings.

As always, it comes back to the fundamentals and understanding the companies you are investing in. Interest rates are not going to shoot through the roof tomorrow, but there needs to be a return to normalcy in terms of the cost of borrowing. Don’t be caught by surprise when interest rates rise, and do your research on those investments that you hold. 

Do you have a question or a company you would like us to take a look at?
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