Topics covered include:
- How future short-term interest rates, inflation expectations, and term premiums impact long-term interest rates
- How each of those rate drivers contributed to the close to 1% drop in interest rates in the past three months
- How yield to maturity is our guide to locking in a fixed return using individual bonds or bullet ETFs
- How bullet ETFs work and what are some examples
- What are callable bonds and how to analyze them
- How to analyze municipal bonds
- Why we might want to lock in higher yields today
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 463. It’s titled “How to Lock in Higher Yields in Case Interest Rates Fall.”
Short-term Interest Rate Expectations
Last week in our free Insiders Guide email newsletter I wrote about how the consensus of financial market participants is that cash yields will fall. Central banks are the entities that determine what cash yields are because the yields on cash such as for CDs and money market mutual funds are tied to central bank policy rates. Right now, the US Federal Reserve policy rate, also known as the federal funds rate, is in a range between 5.25% and 5.5%. And it’s been that way since July.
The Federal Reserve Bank of Atlanta publishes a chart where they look at expectations for the policy rate going out into the future, and market participants expect the Fed funds rate to be less than 4% by September 2024, and we’ll end the year around 3.6%. That’s a 1.5% reduction in what we can earn on cash.
After sending out that email newsletter which you can sign up for at MoneyForTheRestOfUs.com, one of our listeners wrote “Given that cash yields are predicted to fall, would Bullet ETFs lock in current rates? If so, why wouldn’t investors who believe the falling yield prediction lock in current rates well into the future?” That’s what we’re going to discuss in today’s episode, how to go about doing that, including what’s a Bullet ETF.
What Determines Interest Rates
Longer term interest rates are a function of expectations for future short-term interest rates. I just relayed how the market expects short term interest rates, cash yields in the future, the policy rate to be lower by the end of 2024. And because an element of what determines interest rates is based on those future expectations, we have seen longer term interest rates fall.
US Treasury bond yields have fallen between 0.8% and 0.9% from mid-October 2023 through yesterday, and that’s for bonds that mature between 5 and 30 years. So that expectation of future short-term rates does influence longer term rates. There are two other elements though. Inflation expectations also determine long term interest rates. And what we can do is we can compare the yield on nominal government bonds to the yield on inflation index bonds.
For example, the current yield on us 10-year nominal Treasury bonds is 4.11%. The yield on 10-year Treasury Inflation Protected Securities is 1.8%. The difference is 2.31%. Market participants expect inflation over the next 10 years to average 2.31%. If we go back to October 19th, 2023, those inflation expectations were 2.5%. That was the difference between nominal 10-year Treasuries and 10-year TIPS back then. That’s the second element, inflation expectations.
The third element is sort of a catch-all. It’s called a term premium. It’s additional compensation that investors want in addition to their expectations for short term rates in the future, and inflation expectations. It’s really a catch-all to capture that uncertainty about what the central bank will do, or what inflation will be. It’s also reflective of supply and demand. If there’s much greater supply of bonds or issuance of bonds compared to the desire to hold those bonds, that can push up rates, and that would be captured in that term premium.
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