How an interest rate increase will affect your portfolio

09 November 2017 by National Bank
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On July 12, the Bank of Canada hiked its benchmark interest rate, recognizing the strength of our domestic economy and tightening monetary conditions for the first time since September 2010. This was followed by a second increase on September 6, 2017 confirming the trend.  Investors should bear in mind the impact these rate hikes could have on their portfolios.

Bonds: Decline in short-term performance

The central bank’s actions could be beneficial for investors in the long term, since new investments can be made at higher interest rates. However, these future gains come at the expense of the bond portfolio’s short-term performance. Interest rates and bond valuations are like two sides of a scale: if the one side goes up, the other invariably goes down. However, keep in mind that unless the bond issuer has declared bankruptcy, any decline in market value will be temporary, since the issuer will continue to pay coupons periodically and repay the borrowed principal at maturity.

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In fact, central banks only control the overnight interest rate, while the rates for longer-term securities are dictated by market trends. For fixed-income securities, this valuation is generally a function of expected inflation and future movements from central banks. In recent years, we’ve seen that key rate increases from the U.S. Federal Reserve are often followed by a drop in longer-term yields.

How can you protect your bond portfolio?

There are a number of approaches investors can adopt to protect their bond portfolio from a potential interest rate hike:

  • Reduce the average duration of your bond portfolio The closer a bond is to maturing, the less likely the value will be affected by rate fluctuations. However, there’s a downside: a lower expected return in the long term. In fact, the normal interest rate curve offers greater returns when the maturity date is further away.
  • Invest in a global bond portfolio Since interest rate hikes are not synchronized worldwide, a global bond portfolio could lessen the impact of volatility in the Canadian market. However, caution should be taken with this type of investment, since the financial crisis in 2008 led to bonds in a number of countries being offered with very low—even negative—yields. Holding bonds with a negative yield at maturity is not a recommended long-term investment strategy.  It’s also important to check whether or not a global bond investment is hedged against currency fluctuations, since this can have a major impact on its performance.
  • Invest in floating-rate bonds As their name implies, the interest rate on this type of bond is not fixed until maturity, but is reset every quarter based on short-term interest rate levels (usually LIBOR in the U.S. or CDOR in Canada). This allows the investor to quickly benefit from market rate increases, and, since bonds are reset periodically, there is very little impact from rate fluctuations. However, most of these securities have a credit rating that is below investment-grade, so holding them is an increased credit risk.

Maintain a holistic approach to your portfolio

Before adopting a new strategy involving fixed-income securities, investors should take a closer look at their overall portfolio. Even if the expected return is low for the next few years, these bonds provide a certain degree of stability in periods of stock market turbulence—an insurance policy that can be weakened by implementing alternative strategies.

When interest rates go up, investors need to maintain a holistic view of their portfolios. When a central bank tightens its monetary policy, it means that the underlying economy is in good health. This economic health should translate into a strong stock market and corporate debt market, resulting in attractive overall returns for the total portfolio.

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