Rising interest rates, and often more importantly in the world of investing, the “expectation” of rising interest rates causes a negative reaction in bond/fixed income investments. This is because interest rates and bond prices have what is called an inverse relationship. When interest rates fall, bond prices go up. When interest rates rise, bond prices go down. This is what we’ve seen so far in 2022.
This has made many fixed income investors nervous, particularly those holding bond funds, many of whom have seen year to date declines in excess of 10%. But what should be done as a result of these declines? Do we sell our fixed income portfolio and go to cash? Do we increase our risk, and invest more heavily in equities? And what will the Bank of Canada do going forward? Will they continue to raise rates? They might. And by how much? We really don’t know. It depends how quickly they can get inflation under control.
Before selling out of our fixed income positions, assuming they are still being managed by exceptionally knowledgeable and skilled portfolio managers, let’s consider some potential opportunities that the current environment is presenting to us.
Even though rates have risen quite rapidly, and it has caused bond prices to fall in the short term, it has resulted in some attractive yields, compared to 6-9 months ago. For example, as recently as December 15th, 2021, 90-day Government of Canada treasury bills had a yield of 0.04%, while a 1-year T-Bill would pay you 0.7%. Today, those same treasury bills are offering 3.5% and 3.91% respectively - a fairly drastic change. Consider as well that Government of Canada treasury bills are often called “risk free” investments because of their high level of safety.
GIC rates have been affected in a similar fashion. A 1-year GIC is currently yielding as high as 4.7%[i], while a 5-year GIC is paying 5% at the high end. Compare this to 2021 when many 1-year rates were yielding below 1%, and 5-year rates hovered between 0.80% and 2.10%[ii].
For many years now, fixed income investors have been concerned (and understandably so) about the low interest rates being offered for fixed income investments. There was a lot of pressure to “risk up” their portfolios into higher levels of equity investments to generate returns needed to fund their long term needs and goals. This recent change, which has come at a short-term cost, also creates new opportunities to increase portfolio income going forward.
For bond portfolio managers, there are opportunities where bond sell offs have been greatest. For example, per a recent article from Fidelity, “One result of the end of the bond bull market is that prices of many bonds, especially high-quality corporate bonds, have become cheaper than what the issuing companies’ fundamentals would suggest they should trade at.[iii]” What this means is that the rapid rise in rates, have caused many investors to overreact and oversell high quality positions. This creates opportunities to pick up bargains for thoughtful portfolio managers.
Where is Inflation heading?
Another factor is to consider inflation and where we think it’s heading? As we know, the central bank is working aggressively to bring it under control. So far, it has leveled off from its rapid increase (sitting at 7% as of August 2022); however, it’s still not where the Bank of Canada wants it to be (close to 2%). The same goes for the United States, and other developed nations. This is where it gets interesting for the fixed income investor. If the Bank of Canada raises rates again, which is a good possibility, it is likely that fixed income prices will drop again. On the other hand, at some point in the future, the interest rate hikes will cause borrowing costs to become expensive, and this could eventually create a recession. If a recession becomes a reality, there is a good possibility the Bank of Canada will need to begin lowering rates to stabilize the economy. If this were to occur, then bond prices would eventually begin to rise.
Either way, yields are quite a bit higher than they were a year ago, which is positive for fixed income investors regardless of recent short-term pain, and there is good potential for improvement to their holdings going forward.
Investments that Benefit from Rising Interest Rates
One way to balance out concerns about rising rates is to consider investing in floating rate funds. Floating rate funds invest in a basket of securitized bank loans that come with interest rates that are variable. As a result, in a rising interest rate environment, the bank loans will have higher interest payments, which is beneficial to the investor. The downside of floating rate funds is that the investments within the fund tend to be below investment grade, making them more susceptible to defaults if we were to enter a recession. At the same time, for investors with a higher risk tolerance who wish to diversify their fixed income holdings, this alternative to a high yield bond fund can be a useful tool to take advantage of rising rates.
The Big Picture:
Like any form of market timing, it is extremely difficult to predict when market events will happen and how they will impact our portfolios. Our philosophy remains unchanged. We will work with you to build a portfolio that is suitable for you given your investment objectives and overall financial and personal goals and needs. For most investors, that will include holding a component of fixed income. When equity markets are down, fixed income should reduce the volatility of the overall portfolio, as it has done to a certain extent this year, particularly when comparing to the returns from the US and International markets.
The volatility we have seen in all asset classes in 2022 creates an opportunity for us to review client portfolios to ensure that the asset allocation percentages that were originally tailored to them individually are still in place. If the portfolios have diverged from their set strategy, we can rebalance them. As we’ve discussed in the past, rebalancing a portfolio involves the selling of assets that have performed the best (even in a year when their returns might have been negative), and the buying of assets that have performed the worst. It therefore becomes the equivalent of buying low and selling high and it’s a process that we can undertake without having to make a grand call on what will happen next in the global economy.
Fixed income will remain an important component of investor’s portfolios going forward, regardless of whether they need it for income, diversification, risk reduction, or all three. The key is to a plan, and that’s what we’re here to provide here at LGK Wealth Management.
If you’d like to discuss this topic further, please call us at (780) 426-2400, or e-mail us at email@example.com to schedule an appointment.
[i] Source: Ratehub.ca – Sept 27, 2022
[ii] source: https://lifeannuities.com/articles/2021/best-gic-rates-canada-2021.html