A few days ago, a co-worker dropped a letter on my desk he received from the financial services division of a luxury automobile manufacturer. Since he owns one of their higher priced models, they figured he might be willing to allow them to use his cash to lend to new car buyers. They’re willing to pay him 1.7% on his money. That is much higher than what he can get on his savings account at the bank.

Interest rates are on the rise. Companies that need a lot of cash to lend to customers buying on credit are starting to feel the pinch. Their profit margins are largely a function of the cost of capital versus the price at which they can lend it out to new car buyers. That means every fraction of a percentage point is worth a lot of money to them.

An unsolicited offer like this is one more sign that inflation is on the rise. It should also serve as a warning to bond investors that rougher days lay ahead. For most of the past 35 years, we have only known declining interest rates. Now that they are rising, income investors need to think differently about the risk in their portfolios.

Changing Lanes

The price of a bond moves in the opposite direction of interest rates. When rates are falling, the price of a bond goes up so that its interest payment is equal to what new bond issuers must pay to attract investors. So, there has not been much incentive for bond issuers to think outside the box since Ronald Reagan was president.

Now that interest rates are on the rise, I expect to see a wide variety of new debt offerings come to market. Some of them will offer a variable interest rate, so that the value of the bond will remain constant. Other bonds will offer some sort of equity kicker, or be convertible into shares of stock. Those types of bonds have been around for a long time, but will become more popular with investors as rates rise.

The problem with both convertible and variable rate bonds is that they can end up being more expensive to the issuer than a fixed-rate bond. If bond issuers had things their way, they would lock in their profits the day they issued the bond rather than risk having to pay a higher rate later on or dilute the value of their equity.

For that reason, many companies will look for cheaper alternatives to issuing those types of bonds. Reaching out to their customers as a source of capital is one way to do that. But I wonder how many of those people are capable of evaluating the risk involved. For example, what rights will they have if the company that is using their money goes bankrupt?

Pumping the Brakes

I fear that fraudsters will take advantage of the public by offering what seem like good deals, but are really Ponzi schemes. So long as rates keep rising, they should be able to find new sources of money to pay interest to their existing customers. Bernie Madoff was able to keep that type of scam going for decades using stocks, so imagine how much easier it would be using what appear to be bonds.

There are safer ways to generate high income. I believe rising inflation will increase the value of real estate and hard assets. In that case, using REITs (real estate investment trusts) or energy MLPs (master limited partnerships) is one way to earn high income and possibly even grow your capital while rate are rising.

What I would not do is jump into an unproven means of earning high income. Ten years ago, the global financial system nearly collapsed thanks to reckless real estate lending. You’d think we all learned our lesson from that, but human beings have a nasty habit of repeating past mistakes.

Before you put your hard-earned money into any investment, make sure you know all the risks. Otherwise, you may find yourself washing that luxury automobile for a living instead of driving it.

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