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How the Fed Is Affecting Income Investors

U.S. News & World Report - Money logo U.S. News & World Report - Money 9/14/2017 Jeff Reeves
The Federal Reserve Building in downtown Washington DC, USA at night. HDR image.: Rates are theoretically higher in the near term, but still low when compared with historic norms. © (Getty Images) Rates are theoretically higher in the near term, but still low when compared with historic norms.

The U.S. Federal Reserve has long been a powerful institution. But in the last 10 years or so, the power of the organization has been particularly apparent on Wall Street.

In response to the 2008 financial crisis, the Fed cut key interest rates to historic lows with a larger range of zero to 0.25 percent. As a result, the 10-year U.S Treasury bond dipped to an annual yield of less than 3 percent – the lowest levels since the 1950s.

Nowadays, however, the Fed is ostensibly moving toward higher interest rates with three small interest rate increases since December. Now that rates have gotten off their historic lows, it's natural to wonder how quickly the bond market will adjust.

[See: 9 of the Best High-Yield ETFs on the Market.]

But most experts say it's not likely bond investors will see any big changes anytime soon.

"Yes, rates have risen over the last year but all maturities rates remain low by historical standards," says David Jilek, chief investment strategist at Gateway Investment Advisors. "As the Fed has moved to normalize monetary policy the yield curve has flattened with short-term rates rising more than intermediate and long-term rates."

In other words, rates are theoretically higher in the near term, but still quite low when compared with historic norms. Furthermore, while shorter-term bonds may be yielding a bit more, long-term bonds still deliver paltry annual yields.

Despite the rhetoric, Wall Street doesn't expect the interest rate picture to change very much for quite some time.

It's helpful to provide some context on just what the Fed is trying to unwind.

For starters, consider that while the 10-year Treasury note was yielding 5 percent or so in the mid-2000s and is stuck under 3 percent currently, the government bonds offered an annual yield of more than 10 percent back in 1985 and regularly traded above 6 percent in the 1990s.

The drop in interest rates is hardly a recent phenomenon brought on by the Great Recession. In fact, it's a long-term trend.

That's because the Fed doesn't really exist to protect savers by providing comfortable rates on bonds, CDs and other interest-bearing assets, says Michael Arone, chief investment strategist at State Street Global Advisors. In truth, Fed's dual mandate involves simply keeping a wrap on inflation and keeping the job market functioning well.

Those two charges are what makes it hard for rates to move higher, he says.

"The Fed's preferred measure of inflation" only shows "a modest 1.4 percent for the last 12 months," Arone says. "Not only is this well below the Fed's inflation target of 2 percent, it has been consistently decelerating since the first quarter. It's unlikely that inflation will reach the Fed's target anytime soon."

As for the jobs picture, while the unemployment rate recently hit its lowest levels since 2001 and the current jobless rate of 4.4 percent remains well below historical norms, a slowdown in job creation and weak wage growth over the last several years hints that the U.S. job market may not be ready for tighter policy just yet.

What does this mean for stocks and bonds? Likely more of the same.

High-quality corporations continue to enjoy easy access to capital in this low interest rate environment. Just consider Apple (AAPL), which held its first bond offering in history back in 2013 despite sitting on more than $150 billion in cash and investments at the time.

And why not? The tech giant sold $5.5 billion of 10-year bonds that yielded 2.415 percent annually that year – a meager 0.75 percentage points "better" than 10-year Treasury bonds at the time. Getting that much money for a decade with that little in interest payments is a no-brainer for Apple and others in its position.

That's great for Apple, yes, but it's not much fun for bond investors who have to settle for the low yields.

Along the same lines, many troubled companies that would have had trouble raising capital in years past have been enjoying big demand for their debt as bond investors take on riskier investments in pursuit of higher yields. Earlier this year, yields on the typical U.S. junk bond fell to just 5.56 percent – a record low.

But considering where Treasury rates are, what alternative do people have if they want yields in the ballpark of 5 percent or more?

"Given current economic conditions, nobody – including the Fed – expects interest rates to get back to pre-crisis levels anytime soon," Arone says.

That leaves few options for investors looking for yield, regardless of what the Fed and other officials may say about rates moving higher. Right now, just about the only place you'll find consistent annual payouts of 4 percent or more are in high-yield junk bonds or dividend-paying stocks.

As the old saying goes, higher potential reward in these trades comes with much higher risk. And investors should expect this dynamic to remain – even if higher yields in the low-interest-rate environment still remain significantly below what they may be used to.

[See: 10 ETFs to Buy for Aggressive Growth.]

Barring an unexpected outbreak of inflation, which seems highly unlikely, "it will take a long time for short-term interest rates to get back to 5 percent," Jilek says.

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