June 1, 2000
Trust Deed Investing In A Changing Economic Environment
By Richard C. Temme
Unemployment is hovering near record lows. There is strong upward pressure on wages. Many people share a concern that our country is on the verge of a classic cost-push inflation cycle. The potential of inflation, although not a problem at this time, could become serious if preventive measures are not taken.
Alan Greenspan is leading the Federal Reserve Bank (the Fed) to a slow and deliberate increase in interest rates in an effort to slow the economy. He clearly does not want to take chances with inflation.
It is important to point out that tools available to the Federal Reserve, enabling it to control interest rates, generally only allow the Federal Reserve to control interest rates in the short-term money market and in the overall supply of money.
It is very difficult to predict how the long-term interest rate market will react to a specific action by the Federal Reserve to tighten or loosen short-term interest rates. We have seen long-term debt instruments increase in yield when the Federal Reserve raises short-term interest rates. However, on May 16, 2000, when the Fed increased short-term interest rates charged to banks, interest rates on long-term federal debt instruments actually fell even lower. That made the 30-year Treasury bond yield approximately 65 basis points below the two-year Treasury bill yield. This drop in long-term interest rates was due to investor anticipation of a reduced rate of inflation.
The last extended period when short-term T-Bills yielded more than the 30-year Treasury bond was in the early 1990's. This was just before an economic recession and drop in long-term interest rates.
Many large investors currently believe that long-term interest rates will eventually be lower as a result of the Fed's determination to prevent inflation. Therefore, they are buying more long-term debt, forcing down long-term interest rates relative to short-term rates. A result is, currently, the interest rate on a 30-year treasury bond is less than on a two-year T-bill.
What does all this mean to trust deed investors? Assuming the professionals are correct in their thinking, we might take a lesson from them and acquire as many longer-term trust deed investments as we can. Prepayment penalty protection will be more important than normal to investors applying this philosophy. Further, interest rate declines, when they come, will be predicted on the anticipation of a slowing economy. One problem with slowing economies is that, at the beginning of a cycle, we usually have no idea as to how much the economy will ultimately slow. Trust deed investors will feel more secure during any economic slowdown if their portfolio tends to the conservative side. That can usually be accomplished by mostly holding loans secured by first deeds of trust or second trust deeds with better than average equity protection.
What happens if inflation is not so easily prevented and the Federal Reserve continues to raise rates past their next meeting? Will longer-term rates then continue to rise? It is difficult at this time to predict what would result. It is important to remember, at such time as investors recognize that the Fed has prevailed in the current effort to prevent inflation, long-term rates will probably plummet. It is very unlikely that there will be time to try to lock-in high rates once victory in the inflation battle has been acknowledged. The moral of all this is that investors who agree with this thinking may want to start early in any accumulation of longer-term trust deed investments. Again, prepayment penalties will be very important to investors utilizing this approach to trust deed investing. Experienced trust deed investors recognize that the vast majority of long-term trust deed investments will pay off early, despite prepayment penalty protection.