Interest rates have steadily been on the rise over the last year, leading to the question whether investors are prepared to manage their portfolios properly as this trend continues during 2014.
The 10-year Treasury yield has experienced a 100 basis point rise on an annual basis. As of this morning, the U.S. 10-year yield climbed three basis points to 2.74%, and one executive would not be surprised to see a similar 100-point increase for Treasury yields by the end of this year.
"This is a long-term trend as it relates to fiscal monetary policy and effectively the unwinding of the largest balance sheet ever acquired by a central bank anywhere," says Steve Sachs, head of capital markets for Bethesda, Md.-based ProShares. "This will take many years to unwind and effectively, this multi-decade trend of interest rates declining is effectively ended."
But Ted Ahern, CFO at Guaranteed Rate, has a different perspective on the 10-year Treasury yields as he believes they are fairly priced. Additionally, low inflation is leading to very high credit quality which means there's not a lot of risk out there for investors.
"Underwriting standards, particularly in the mortgage space (especially the residential side), have been more on the conservative side over the last several years," Ahern told this publication in an interview. "So people aren't getting paid to take higher risk in the residential mortgage space from a yield perspective. So you combine low inflation with very high credit quality, I think mortgage interest rates are very fairly valued currently."
The average rate for a 30-year fixed-rate mortgage dropped two basis points in Freddie Mac's survey through the week ending Jan. 23 to 4.39%. This is about 1% higher than a year ago.
However, the 15-year rate fell by one basis point to 3.44%, which still though represents a 73 basis point increase from a year earlier.
"Mortgage rates have settled over the last few days, as we're in-between market-moving events," says Keith Gumbinger, vice president of HSH.com. "The soft December employment report is behind us; the next Fed meeting, where we may or may not get another cut in Treasury and MBS purchases, is coming up. Investors are watching their incoming data closely for signals that the Fed will or won't make a move, so interest rates are holding fairly steady at the moment."
As the 10-year Treasury yields go up and mortgage rates keep increasing from all-time lows, what factors will impact how much longer investors are going to remain dominant factors when it comes to buying homes nationwide?
Institutional investor purchases—entities that bought at least 10 properties in a year—accounted for 7.3% of the 5.1 million U.S. residential sales in 2013, according to data from RealtyTrac, which is up from 5.8% the year before and 5.1% two years ago.
What hurts an investor's portfolio the most right now is that rates have basically gone in one direction since late 2012 and throughout 2013: up.
Investors and the investment professional community—the financial planners, advisors, and institutional money managers—have been using bonds to diversify and manage risk in client portfolios. But those same bonds now are the source of the risk because as interest rates rise, bond prices fall. The opposite happens, too.
Furthermore, most bond categories saw negative returns in 2013 and investors have not seen that occur for a very long time. So the first risk investors face is whether they even understand this concept, Sachs says.
"Certainly financial professionals do, but it's a much different conversation with the individual investor when they say 'we were buying these bonds because it was supposed to be diversifying my portfolio and protecting me from loss, and now what's going on,'" Sachs continued.
Overall, the national and global economy is improving. In the last quarter, U.S. GDP growth was 4%. However, a better economy also typically leads to higher interest rates.
An interest rate shift from a declining environment to a rising one does not typically happen in an orderly fashion. So volatility and fixed-income will increase over the course of 2014 and maybe even next year too, Sachs says.
"That's going to be more of a trigger for people than a specific level for interest rates to reach," Sachs adds. "But we're a ways off of a particular absolute level where it starts to hamper economic growth."
Also, the Federal Reserve trimmed quantitative easing purchases by $10 billion at its December meeting and the government agency is expected to scale back purchases of mortgage-backed securities and Treasuries at a similar amount over the next seven Fed meetings. However, this decision will only occur if the economy is performing at a satisfactory level.
"If rates are rising, it probably would be conflicted with a strengthening economy and real estate values going up," Ahern says. "We're probably going to see a little bit of a slowdown in housing in 2014 as a lot of markets will see a lack of supply, but this would be a scenario-by-scenario case basis due to which cities have a large volume of distressed assets."
Lastly, unemployment is one of the biggest issues that will determine whether an investor will continue buying housing units. Through December, the unemployment rate was 6.7%, the Department of Labor reported. Even though only 74,000 jobs were created during the month, jobs have been growing at a healthy pace in the U.S. throughout 2013, between 185,000 and 200,000 jobs per month.
"The biggest thing we have to get over as investors and consumers is that we have to reset our expectations back to long-term averages (10-year average unemployment rate is 6.4% and 20-year average is 6.2%)," Sachs says. "At the end of the day, the employment picture has improved in this country and it continues to improve. Investors and consumers continue to take heed of that, and ultimately, this is what drives us as consumers to either make an investment or buy a house or spend money."