A Personal Finance Guide

An Investor Nightmare Waiting to Happen

In order to claw our way out of a scary recession, we’ve dropped interest rates to artificially low levels to stimulate the economy. What happens to our financial institutions and our pocketbooks when interest rates go back up?

The financial giants like major banks, brokerage firms, and life insurance companies lead us into this mess. Wall Street created and spread derivatives and toxic assets (like sub-prime mortgages) like a virus, infecting every corner of the globe!

The U.S. government is talking trillions of dollars to clean up the mess … with borrowed money of course. When the large financial institutions finally get their reserves and their investment portfolios cleaned up, then what?

What kind of investments will they and investors in general be holding? As usual, they will be holding debt instruments like bonds and mortgage backed securities. Also, investors large and small will be holding equity investments like stock.

Portfolios might own cleaner debt securities in the not-too-distant future, but they will be holding securities that pay low interest rates. For example, today the yield for a 30-year T-bond is 4%, and folks can get a conventional 30-year mortgage for less than 5%. Since T-bills and money market funds are paying virtually nothing, many investors are chasing the higher yields offered by this long-term debt.

Now, picture interest rates soaring. And picture what would happen to the value of a long-term debt instrument with a fixed interest rate of 4% or 5% when prevailing rates zoom to 8% or 10% or higher. How much would you pay for a bond paying 4% when new ones offer double that? The value of bonds in investor portfolios would fall like a rock.

Financial institutions with tons of these low-interest-rate securities in their portfolios would again be in severe financial trouble, including pension funds. How do we clean up the mess this time?

How do stocks perform when interest rates soar? The economy slows down, as consumers buy less and fear for their jobs. Corporate sales slow, and the cost of financing goes up. The bottom line is that earnings fall, and likely stock prices as well.

I hope the nightmare of soaring interest rates never materializes, but all things are possible in the real world of financial markets.

Don’t just buy investments, hold and ignore them. Pay attention and have a plan, an investing strategy. Get familiar with the various investment classes. Some do better than others when adversity strikes.

A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.

Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com