Date: 04-Jan-2014
Background
Recent money out flow from fixed income investment creates some tempting opportunity. Some close end municipality funds have yield above 6%. Is it a good time to purchase fixed income now? Will interest rate increase in the future? What will happen when interest rate increase?
Historical Interest Rate
To guess the future, you have to look to the past. According to Yahoo Finance, ten year interest rate was at its lowest point at 1.6% around July 2012. The highest interest was 15.84% in July 1981. Interest rate was between 4% and 6% most of the time. This information is shown in the captured Yahoo CBOE Interest Rate 10-Year T-Note graph below.
What will happen when interest rate change?
When interest rate increases, investor can obtain same amount of interest payment with less principle. For investor to purchase existing fixed income instrument, price of the existing fixed income instrument has to come down. Interest paymant has to be the same amount before and after interest rate change. This can be expressed in an equation:
(100 – x) * (i + di) = 100 * i
Where:
100: current principle, in 100%
x: principle amount decrease, in %
i: current interest rate, in %
di: interest rate change, in %
Solve this equation to get the principle amount change:
X = 100 * di / (i + di)
When interest rate increases from current 3% to assumed long term interest rate of 5%, principle change can be calculated by using current interest rate of 3% as i and 2% as di (interest rate change, 2% = 5% – 3%):
X = 100 * 2% / (3% + 2%) =40%
Conclusion
When interest rate reverts to its long term range around 5%, existing fixed income investment with 3% interest has to shrink its principle 40% to create a 5% yield. That is a huge price drop. Now is not a good time to purchase fixed income investment. It is too risky to pick up a penny in front of an incoming train.