Will the Fed's actions affect your portfolio?

How the Federal Reserve's next big move will change everything for income investors.

By InvestingAnswers Jul 16, 2013 5:12PM
By Tina Orem                                                                   

Every summer, some catchy-but-annoying teenybopper tune is dubbed "the song of the summer," and then we all have to hear it 50 times day on the radio. Given the recent speculation about the possible end of a huge government stimulus program, and the resulting chain-reaction flight from dividend stocks, this year's song should be The Fixx's 1983 hit "One Thing Leads to Another." 

The fact that the song is a fossil from the 1980s doesn't matter. It only emphasizes the simple truth -- that the domino effect is an age-old rule of investing, pre-dating even acid washed clothes and hair crimping.
Back in early 2012, the Federal Reserve began buying up Treasury bonds -- as much as $85 billion worth a month. The goal of the Fed's quantitative easing program is to put cash in the hands of banks and other large institutions that hold Treasury bonds. They, in turn, take that cash and lend out nearly all of it, and all that new competition in making loans to you and me would mean nice low interest rates for everything from cars to mortgages.

So far, rates have stayed low, and the lesson here is that if you're the government and you want to keep interest rates low, one way to do it is to start buying your own bonds back.

But remember, one thing leads to another. 

Image: $100 dollar bills © Image Source, age fotostockTwo other fundamental laws of finance affect this strategy: The price for things goes up when there is more demand for those things, and when bond prices rise, their yields -- that is, the annual coupon payments divided by the bond's price -- fall. 

Most people understand that first law about supply and demand. But fewer people understand the second law of finance: When bond prices rise, their yields fall. 

Here's how it works. Let's say we have a bond with a $1,000 face value and a 2% coupon. That bond is going to pay you $20 a year in interest payments (2% of $1,000). Now let's say that everybody suddenly wants a piece of that bond, and the price gets bid up to $1,100. Anybody who pays $1,100 for the bond, which still pays out $20 a year, is really getting only a 1.8% yield ($20/$1,100). 

Conversely, let's say nobody wants the bond anymore, and so the price of it goes down to $800. The bond still pays out $20 a year, however, so whoever buys the bond for $800 is getting a bond that yields $20/$800 = 2.5%.

As you can see, when bond prices change, their yields go in the opposite direction. 

Now consider that in the context of the Fed's bond-buying program. With every new report about improving economic performance, it has less incentive to keep trying to stimulate the economy, and thus less incentive to keep buying billions of dollars of Treasury bonds. So what would happen if the Fed stops?

One thing leads to another. The demand for Treasury bonds would go down, and the price of Treasury bonds would go down. In turn, the yields on Treasurys would rise. 

That's when investors start asking questions. They might ask, for example, if I can get a 3% or 4% yield on a nice, safe Treasury bond, why should I blow my money on dividend stocks that have the same yield but a whole lot more risk attached?

The answer? They shouldn't. And that changes everything for income investors.

That's why many of those dividend stocks are going to have to raise their dividends if the Fed stops buying Treasurys. Otherwise, they're just not going to be able compete for investors' attention (and dollars), and their values will go down. All the other bonds out there will face the same fate, too, if they aren't offering yields that make the risk "worth it" to investors.

The interesting thing about the Fed's plan to end its quantitative easing program is that it hasn't stopped it yet. Nonetheless, once the market gets wind that something is close to happening, it might as well be over and done with, because investors are already trying to get a jump on things. Instead of waiting for the Fed to announce the end of the program and suffer the price drop in dividend stocks when it happens, they figure, why not get out now?

It's a fair question, but one thing leads to another.

The Investing Answer: A big reason the financial world is so complex is that it's so interconnected. That's why you may find yourself wondering why some of your dividend stocks are flailing when the Federal Reserve finally changes its shopping habits. Most investors don't understand why something "over here" has anything to do with something "over there," but knowing the simple relationship between bond prices and bond yields can save your portfolio.

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