Money Matters: For bond investors, tapering is a scary word

Kevin B. Murray, The Daily Record Newswire

Tapering or tapering off is an adjective meaning to gradually decrease until little remains. In financial terms it currently is exclusively used to refer to the anticipated future reduction in the Federal Reserve Board’s quantitative easing, or massive bond buying program.

For bond investors, tapering means higher interest rates that will inflict heavy losses on their existing bond portfolios. For equity investors, tapering means the Feds record breaking monetary stimulus, which has fueled the stock market rally, will be coming to an end. Equity investors can take heart in that tapering will only come when the economy strengthens. While
for bond investors, a stronger economy and tapering will only reinforce each other in leading to higher interest rates, and thus capital losses.

On May 22 of this year, Fed Chairman Ben Bernanke triggered a market selloff by raising the possibility of reducing the Fed’s stimulus at some future point, depending on the health of the economy. The record breaking rally on July 11 was fueled by Mr. Bernanke’s reassurances the night before that the Fed would continue to pour cheap money into financial markets.
The rally led to all-time record closing’s for both the Dow Jones Industrial Average and the Standard & Poor’s 500 Index. The NASDAQ closed at its highest level in thirteen years.

The fear of tapering has, according to most observers, been the chief cause of the increase in interest rates since May that has caused losses for bondholders and driven mortgage rates higher. Higher mortgage rates threaten to derail the recovery in housing, which is seen as a vital part of the fragile economic recovery we have been experiencing.

Currently the Fed is buying $85 billion a month in bonds to keep interest rates low and to encourage spending and hiring. The Fed has said it plans to keep short-term rates at record lows, at least until unemployment falls to 6.5 percent. On Wednesday, Mr. Bernanke indicated that the 6.5 percent level of unemployment is a threshold, not a trigger. In fact the Fed may decide to keep short-term interest rates near zero even after unemployment falls to 6.5 percent.

Equity investors reacted very positively to Mr. Bernanke, as he assured them that the Feds monetary stimulus will last for quite some time, and will only be lessened after the economy has shown sufficient strength to withstand a lessened monetary stimulus. Thus equity investors will continue to be helped by cheap money until the strength of the economy shows it is no longer needed.

Bond investors, on the other hand, have seen longer term interests rates rise (mortgage rates are at their highest level in over a year), on every hint of future tapering. Unlike equity investors, who benefit by signs of strength in the economy, bond investors see longer term interest rates rise with positive news on the strengthening of the economy, in part because that increases the chances that the Fed may soon begin to taper their asset purchases.

With interest rates currently at low levels, and expected to rise, bond investors, who have had a great run as interest rates have been continually falling, are facing the prospect of substantial headwinds in the future. Until recently bond owners could count on capital gains as interest rates declined in addition to the coupon the bond paid. Now they are facing low initial coupons and the high likelihood of capital losses as future interest rates rise.

Tapering is an eight letter word, but to bond holders it may very well seem to be a four letter word.


Kevin B. Murray is a vice president at Karpus Investment Management, an  independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.