Q2 2013 Market Summary for Clients

The big news in the markets for the quarter was the huge move higher for interest rates. Interest rates experienced the biggest move since April of 1987.

The U.S. Federal Reserve Bank has been buying $ billions of bonds for many months to keep interest rates down in an effort to help the U.S. continue its recovery from The Great Recession. Several weeks ago some of the Fed governors started hinting that the Fed may start tapering the bond buying program as our economy continues to show signs of gradual recovery.

This hint spooked bond markets and triggered a massive selloff almost instantly, and radically, altering the price of bonds, and mortgages, to reflect an altered set of expectations. As I write this the interest rate on the 10 year treasury is about 77% higher (2.65%) than it was 1 year ago (1.50%).

When interest rates head higher the value of existing bonds go down because the promised stream of payments made by bond issuers is instantly worth less relative to a bond that can be purchased today paying the higher rate. Assets like real estate are also affected by moves in interest rates because generally the biggest potential profits from real estate holdings come from borrowing money against the real estate.

Of course 2.65% is still pretty low on a historical basis and 1.50% is crazy low. 30 year mortgages, while higher, are still priced at a relative discount.

What does all this mean for more diversified investors holding thousands of bonds through bond mutual funds? One of the more conservative funds I use, that holds a lot of government debt, got punched in the nose to the tune of a 3.27% drop for Q2 2013. This is a tiny fraction of the potential drop stocks can, and have, incur(red) when things get ugly so even though we experienced a setback bonds actually did their job and continued to provide us with income and relative stability.

Bond funds also have a built in recovery mechanism where the individual bonds in the funds are continually returning interest and principal so new bonds can be bought with the new higher interest rate. History tells us that even in rising interest rate environments bond funds have kept doing their job an overwhelming majority of the time.

Emerging market stocks have been getting killed (down over 11% YTD) for several months as global trade remains low due to the ongoing European recession but emerging market stocks make up about 14% of global market capitalization and that’s where most of global growth will come from over the coming decades.

International developed markets stocks have made us some money (over 5%) this year but U.S. stocks have been keeping us at, or at least scratching distance from, record highs (some funds up over 20% YTD).

As always, I truly appreciate the confidence you’ve place in me with your assets and I want you to feel free to call at any time regarding your portfolio or any personal financial matter.

Sincerely,

Erik S. Wolfers, MBA, CFP®