The Macro Market Wrap Up With The Mad Genius, Vol. 21

Monday I mentioned 5 reasons why a rate hike today will be bad for America now. In and of itself, it’s not, but taken in the context of interest rates rising by 2.5% if the Fed hikes today, overall it’s bad news.

I want to continue where I left off Monday, and what I’ll mention today is pretty important if you have a 401(k) or any other type of retirement plan at work, if you are retired already, or even if you own any bonds. Remember, a bond is simply when a company borrows money, but instead of borrowing from the bank, they borrow from lots of individuals. It’s really just an IOU, but with some legal documents making it official.

One thing I sort of alluded to already is that when companies have to pay a higher interest rate on the money they’ve borrowed, they’ll have less money left over to spend. Now, you and I have left over money and maybe we save it for a rainy day, maybe we upgrade to a nicer hotel room on vacation, or maybe we buy another Lego set for the kids. Companies do the same thing, except instead of vacations and Lego sets, companies spend extra cash on things like new equipment.

The problem now is that if the interest rates on loans are rising, that means that companies will have to spend more money on paying for loans instead of spending it on new equipment, training employees, and other investments in the company itself. That’s bad for the economy because 1) companies are spending less now, and 2) companies will be less efficient at doing what they do best in the future.

Aside from companies spending less, and here is where it matters, like I said companies will have less and less money to spend to begin with as interest rates rise. For example, let’s say Fictitious Trading Company has to spend $1000 every month to pay for its loans and other expenses like the phone, salaries, etc, and to do that they use the profit they make on $1500 of sales. 

What if the amount they spend goes up to $1200? What about $1400? Pretty soon they won’t have any extra cash left over, even to do regular maintenance on their machinery. Even worse, what if their profits are less than they have to spend, meaning they are operating at a loss?

And herein lies the problem for your 401(k). You see, right now about 75% of all the companies in America that have borrowed money from the public, in the form of bonds, are either not worthy at all of your retirement savings, or they are on the brink of being not worthy. There are actually grades for all these bonds, just like you get grades in school. Except for bonds we don’t use A+, A, A-, etc, we use AAA, AA, A, BBB, etc. 

Anything with an A or higher is considered worthy of your retirement plan. BBB is on the brink. It’s still worthy, but it’s almost not, and the risk goes from about 1.0% default to 4.0% default just by going from A to BBB. Currently 75% of all bonds are BBB or lower (on the brink or getting ready to default). 75% of the bonds that are BBB will be downgraded to not worthy (high yield or junk), and of all the bonds that are not worthy, 25% of them will default. That means that if you bought the bond that defaulted, you’re left only with the paper it was printed on, but not your money.

In your retirement account, I’d be willing to bet you probably have some of these bonds that are either on the brink, or are already below worthy, or what we call junk bonds or high yield bonds. How do I know that? Most retirement plans at work have pretty poor options for you to invest in. Many don’t even offer options, and if that is the case, you surely own some of these bonds. If you own a target date fund, you’ve got some of these bonds. If your retirement account is “the enrollment people recommended something for me but I have no idea what the hell it is” then you’ve got some of these bonds.

The bottom line is that unless you specifically opted out of the bond offerings in your retirement account, you’ve got bonds in your retirement account.

And one more thing…when you go to sell a bond, the value of that bond depends on a few things. To keep it simple, lets stick to the main factor, which is the interest rate. If the interest rate is going up, the value of the bond will surely go down. Interest rates and value work like a see-saw. So if the Fed raises rates today, your retirement account will be smaller at 2:01 than it was at 1:59.

That’s it for now. I'll comment again today after the Fed announcement and press conference. Let me know in the comments what your retirement account worries are. Thanks for reading Volume 21 of The Macro Market Wrap Up With The Mad Genius. Until next time remember that there is always a bull market somewhere in the world, and on the opposite side of every crisis, lies opportunity.

#economics #Fed #bonds #ratehikes #retirement