Rate Hike

By Malcolm Berko

September 2, 2015 5 min read

Dear Mr. Berko: What are your thoughts on interest rates? Will the Federal Reserve raise them this year or not? And if the Fed were to raise rates, how badly do you think it would hurt the SPDR S&P 500 exchange-traded fund, which is my largest individual investment and is 55 percent of my equity portfolio. And this worries me.

I'd also like to invest $35,000 in Pimco's California Municipal Income Fund III, which pays 6.8 percent tax-free. Your opinion of this closed-end fund would also be appreciated. — WP, Syracuse, N.Y.

Dear WP: Some wise observers believe that the Federal Reserve will begin to raise interest rates this year, but some equally wise observers believe the Fed won't raise rates in 2015. I think it's a tossup, perhaps a 50-50 chance that the Fed will or won't — which reminds me of my 50-50-90 rule. Most times when I have a 50-50 chance of making the right decision, there's a 90 percent probability that I'll pick the wrong one.

I don't know whether Federal Reserve Chairwoman Janet Yellen will raise rates this year, and frankly, I doubt that she knows what she's going to do. However, I've been told that Yellen is facing steady pressure from the Obama administration and some members of Congress to maintain the current low rates. They're concerned that higher rates would translate to higher borrowing costs for municipalities, corporations and consumers. And they're concerned that higher rates would stifle demand and raise prices for goods and services, causing a drop in our gross domestic product.

The Fed's policy of low rates is one of the two primary reasons your SPDR S&P 500 ETF (SPY-$193) has more than doubled since 2009. The other reason, of course, is the gusher of trillions of easy dollars with which the Fed has flooded the economy. Some market seers believe that a slow shift to higher rates would not presage a market decline or burke the continuing bull market. Rather, it might mean that the Fed believes the economy is healthy and can constructively absorb higher borrowing costs. But as I pointed out in an earlier column, the acolytes of Nobel Prize-winning economist Milton Friedman have a low opinion of the Fed's timing and disagree. Yellen strongly believes that if rates were raised, continuing gains in employment would increase consumer buying power and businesses would be able to raise prices significantly. Apparently, the majority of Fed governors agree with Yellen.

And history confirms this. Since the S&P 500 index was launched in 1957, there have been 14 instances in which the Fed has bumped short-term rates; and the average annual return, including dividends, during those years has been 9.51 percent. The highest annual returns have been during the years when rates have been increased gradually in an economy with low inflation. It doesn't take a high IQ to recognize that these are the conditions we have today. If this market is giving you the woollies and the heebie-jeebies, you can protect yourself by purchasing put options on the S&P 500 index. A put option gives you the ability, for an agreed-upon time frame, to sell the S&P 500 index at today's prices, even if it is 50 percent lower.

Pimco's California Municipal Income Fund III (PZC-$10.77) has paid 6 cents a month, or 72 cents a year, since August 2007, when it was trading at $15. At today's price, that 6.8 percent tax-free yield translates to a taxable 9.8 percent yield if you are in the 30 percent bracket. Its non-leveraged portfolio owns 97 low-rated California municipal bonds with an average coupon of 5.6 percent. That yield is boosted sufficiently by the sale of call and put options, which covers management fees and allows a 72-cent annual payout. The portfolio also has large positions in California variable-rate notes and variable-rate demand notes, certainly a strong plus in a rising-interest-rate environment. Their yields increase as the Fed raises rates, giving shareholders some cushion when interest rates go up. And because most of PZC's munis trade at a premium to par value, the shares trade at a 4.98 percent premium to its $9.76 net asset value. I like this issue.

Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at [email protected] To find out more about Malcolm Berko and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

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