In both the primary and many of the ancillary criteria that determine buy/sell signals, interest rate projections play an important role. Whenstocks are priced at reasonable or discounted levels relative to historical fundamental norms, lowering interest rates can have a strong positive effect. Conversely, especially when stocks are overvalued relative to fundamentals, higher interest rates can be shown to have a very negative effecton stock pricing.

The effect on bonds (and bond funds) resulting from interest rate changes are more straightforward than stock pricing relationships because the effect on stocks at any given time depends on stock price levels. The effect on bonds is direct: Lower rates create higher bond prices, and higher rates result in lower bond prices. The effect of rate changes on bond prices can be more dramatic than many investors realize, with the greater price shifts associated with longer maturities.

FundsFor example, using a base interest rate of 8 percent with the bond trading at par, let’s say interest rates go down 1 percentage point to 7 percent. A 21/2 year bond would generally appreciate 2 percent, a 10-year maturity would gain about 7 percent. And, a 20-year bond would appreciate around 11 percent. If the change was 2 percentage points (rates dropping from 8 percent to 6 percent), the 21/2-year maturity would gain about 5 percent, the 10-year would go up about 15 percent, and the 20-year would appreciate around 23 percent.

Now let’s take a look at the opposite effect, and say rates increased 1 percentage point from 8 percent to 9 percent. The 2′1/2-year maturity would decline about 2 percent, the 10-year about 7 percent, and the 20-year nearly 9 percent. A 2-percentage point increase (from 8 to 10 percent) would drop the value of the 21/2-year bond about 2 percent, the 10-year down around 13 percent, and the 20-year would incur a loss of approximately 17 percent.

These gains/losses associated with changing interest rates demonstrate two points. First, and most important, the market value of bonds of all qualities can change dramatically with changes in interest rates. Second, although in our example we were starting with an 8-percent bond selling at par value, there is not an identical correlation between plus/minus interest rate changes and bond value. This is because of potential capital gains/losses associated with bonds selling below/above par and held tomaturity.

Because of the large potential swings in the market price of outstanding bonds, a timing technique providing a reasonable forecast of rate changes is extremely valuable in both reducing risk and expanding return, In Appendix B, there is an investment level associated with yield-sensitive stocks, those most affected by changes in interest rates. In the closed-end fund application, the attempt is simply to match the yield investment level. When the yield investment level is high, purchase bond funds, and then accordingly sell them when the yield investment level is reduced. The specific bond funds chosen for purchase would usually be those exhibiting the greatest discount relative to historical discount norms, concentrating on funds with longer maturities, which provide the largest potential capital gains.

A good example can be found with one of the Putnam family of closed-end funds, Putnam Premier Income Trust. When Drach went to 125 percent investment at the end of April 1990, the fund was trading at a 15-percent discount to net asset value, at 63/4 per share. In fact, I wrote an article in Barron’s about this Putnam fund, and some similar Putnam issues (”Pummeled, Promising: Why a Pro Favors Four Putnam Closed- Ends”) Barron’s, May, 14, 1990. We began to sell the position at the end of May 1990, when Drach issued a sell indication as the discount narrowed to 8 percent and continued to sell around 71/2. When Drach went to 100-percent investment in late August/early September, 1990 we again became a buyer of the fund at a 21-percent discount at the $61/2 level, and held it until Drach’s investment level was reduced to 37 percent in March, 1991. During the six months we held this conservative bond fund (35% investment in U.S. governments, at the time) it had gained 24 percent to 73/4 and was trading at a 4-percent discount to net asset value.

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