On 12 July, the Bank of Canada has recognized the strength of the local economy and raised its key interest rates, tightening monetary conditions in the country for the first time since September 2010. The Bank has conducted a second increase September 6, 2017, confirming the trend.Investors must now worry about the impact that these increases could have on their portfolio.
Bonds: lower short-term performance
This action by our central bank should be beneficial for long-term investors, as new assets may be invested at higher interest rates. However, the future gain is at the expense of short-term performance of the bond portfolio. Interest rates and bond prices may be represented by both ends of a balance; if the first is on the rise, the second will invariably downward. However, it is important to realize that unless the bond issuer will be forced into bankruptcy, any decrease in the market value of securities is only temporary since the transmitter will continue to pay coupons on a periodic basis and will repay capital borrowed from the due date.
Specify in first that central banks control only the interest rate to one day while the level of securities with longer term maturity is determined by the forces of financial markets. Within the fixed income, this valuation generally reflects inflation expectations and future movements of central banks. In recent years we have seen the US that increases in rates by the US Federal Reserve (Fed) were often followed by a decline in interest rates in the longer term.
How to protect bond portfolio?
For investors wishing to protect their bond portfolio against a potential rise in interest rates, certain strategies can be implemented:
- Reduce the average maturity of the bond portfolio. The longer the maturity of a bond is closer, less the price it will be sensitive to changes in interest rates. There is however a cost to pay for such a strategy, a long-term expected return less. n effect, the normal curve of interest rates provides superior compensation over the expiry of a title is removed.
- Investing in a portfolio of global bonds. Given that interest rate hikes are not synchronized across the globe, a portfolio of global bonds could undermine times of volatility observed in the local market. However, some caution with such an investment because since the great financial crisis of 2008, bonds of several countries offer very low interest rates, or even negative. Hold bonds delivering a return at maturity not negative appears as a worthwhile investment in the long term. It is also important to check if the global bond investment is not covered against currency movements, since this can have a significant impact on its performance.
- Investing in floating-rate bonds. As the name implies, the interest rate paid on these securities is not fixed until maturity, but rather is reset on a quarterly basis in relation to a level of short-term interest rates ( generally LIBOR in the US or Canadian Dealer Offered in Canada). The investor thus benefits quickly to rising market rates and as the securities are reset periodically, they have a very low sensitivity to interest rate movements. However, most of these securities have a credit rating below investment grade, detention therefore comes with an increased credit risk.
Keep a holistic view of portfolio
Prior to implementing a new strategy for fixed income, it is essential that the investor has questions about the role that they play in the portfolio. Even if the expected return is low for the next few years, the bonds provide some stability in turbulent times on the stock markets and the insurance policy could be reduced by implementing alternative strategies.
In a scenario of rising interest rates, an investor must keep a holistic view of its portfolio. Indeed, a central bank that takes a tangent restrictive means that the underlying economy is healthy. But this economic health should translate into a robust stock market and corporate credit, meaning an attractive total return for the entire portfolio.