Remember bonds as interest rates rise

With interest rates starting to rise slowly in Canada, many Canadians invested in fixed income securities might be wondering what they should do now.

With interest rates starting to rise slowly in Canada, many Canadians invested in fixed income securities might be wondering what they should do now.

One of the first reactions many investors might have as they see interest rates rise is to shun bonds as a fixed income investment. This strategy, says Serge Pepin, head of investments at BMO Investments Inc., can be a mistake.

“Many investors may be tempted not to consider bonds because they think we’re in a stage of rising rates,” he said. “In fact, right now we are in an environment of normalizing rates. Interest rates are still at historic lows and even if they go up another 100 basis points they are still historically low.

“Bonds will not be impacted greatly until we get up into a more normal interest rate environment, which could take a while to reach. They still provide good downside protection and mitigate risk.”

TD Bank believes rates in Canada will not rise quickly.

“My colleagues in TD Economics believe that the Bank of Canada will raise the overnight rates to 1.50 per cent by the end of 2010 and further to three per cent by the end of 2011,” said Patricia Lovett Reid, senior vice-president of TD Waterhouse. “So the process of normalizing interest rates is expected to be gradual.”

Bonds provide an element of stability in an investment portfolio by offsetting some of the volatility of stocks.

Bonds are vulnerable to economic changes, such as interest rates. Interest rates and bond prices move inversely. If you own a bond and interest rates go up, the value of your bond on the open market generally will go down.

If you plan to hold your bond to maturity, however, the value doesn’t change because interest rates change. You still get the amount promised. But if you plan to own bonds for investment purposes — if you buy and sell bonds as you would stocks — then interest rates become very important.

One strategy to minimize the effect of fluctuating interest rates is to create what is called a bond ladder.

“A basic bond ladder is created by purchasing bonds that mature at regular intervals,” explained Lovett Reid. “As each bond at the front of the ladder matures, the proceeds are then reinvested in bonds at the back of the ladder. Laddering makes fixed income investing easy because there is no need to guess what interest rates will do in the future.”

Lovett Reid suggests creating a ladder of bonds with an average term to maturity of two to five years and a final maturity of five to 10 years.

Another strategy is to use floating rate notes (FRNs) to protect against the risk of rising interest rates.

An FNR is a bond with a variable coupon that is reset, usually each quarter, based on a short-term interest rate benchmark.

Lovett Reid suggests holding more corporate bonds than government bonds. Currently medium-term, investment grade corporate bonds yield about 100 basis points more than government bonds with similar maturity.

Another option is to purchase bond funds, but you should check and see how the fund is diversified.

“An economy that is improving enhances the appeal of corporate bonds,” said Pepin. “Higher yield bonds also tend to perform with the equity markets. In a diversified portfolio today I’d look for shorter maturity, higher yield and corporate bonds.”

Ultimately, investors need to take a long-term approach to their investments and should not look at any investment product in isolation.

“While rising interest rates could hurt the performance of income-oriented portfolios in the short term, bond market corrections historically have been relatively brief and capital losses may be recovered over the longer term,” Lovett Reid said.

Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors. He can be contacted at boggsyourmoney@rogers.com.