Interest Rates Are Rising. How Will They Impact Your Investments?
Interest rates appear to be rising– since the beginning of May, interest rates on 10 year government of Canada bonds have climbed from 1.67% to 2.43%. GCAN10YR If you hold bonds or high-income funds in your portfolio, you could experience significant losses if interest rates continue to climb.
Over the past 30 years, bonds have provided investors with significant capital gains, (offsetting declining interest income,) as interest rates have fallen from historic highs in the early 1980’s to historic lows last year. Ten-year US treasuries peaked at 15.84% in September 1981. In July 2012, they hit a low of 1.43%. Today, they are at 2.44% USGG10YR
Why are interest rates rising now? The US economy grew at a moderate annual rate of 2.4 percent in the first quarter of 2013–despite the effects of huge government spending cuts. As a result, the Federal Reserve is signalling that it may begin to pull back on its quantitative easing programmes. Markets are betting that higher rates are on the way.
Most experienced investors understand that as interest rates rise, bond prices decline. Unfortunately, many fail to understand that small increases in rates can lead to large declines in bond prices. For example, suppose you own a 10-year bond with an interest rate of 3%. If interest rates were to rise to 4%, the price of your bond would decline by approximately 9%.
As value-based portfolio managers, we do not attempt to time the market. We would simply observe that central banks will have to undo their massive stimulus programs at some point. And when that happens, interest rates will rise. We build robust portfolios, with high-quality dividend stocks as core holdings. On the fixed-income side, we currently hold bonds with short durations to limit the effect of interest rate hikes.
As a result of this conservative approach, our performance has lagged that of some so-called ‘high-income’ funds. However, many of these funds expose investors to significant risk due to large exposures to below investment grade corporate bonds, otherwise known as junk bonds. As interest rates rise, the prices of junk bonds will drop much more that those of high quality government bonds.
Investors are often seduced by the promise of higher returns. However, think of returns as speed. If a travel agent offered you a flight on a brand new plane that would get you to your destination in half the time, you’d likely ask how safe it was. We all understand that there is no point trying to get to your destination in half the time if there is a significant chance that you are going to die on the way.
The relationship between risk and returns works the same way. If you reach for higher returns, such as by demanding that your advisor outperform the market, you are exposing yourself to greater risk. Higher returns almost invariably expose you to a greater chance of significant capital loss.
Does your portfolio contain investments or speculative bets? We are pleased to offer qualified* investors our free portfolio review. It will help you to understand if your portfolio matches your personal risk tolerance. Ask us how>>
*Canadian residents with a minimum $500,000 portfolio.