Historically low interest rates were a lifeline thrown by central banks to help keep economies afloat through the global financial crisis. Ten years later, as the economic outlook rallies, we are seeing these market-saving measures finally being reeled back.
Last month, the U.S. Federal Reserve triggered its third rate hike of 2018, the highest posted in a decade. The Bank of Canada kept its target rate steady at 1.5%, but did not dissuade investors from expecting another rate hike in the near future — likely more so now that there's certainty in a trade agreement with the U.S. and Mexico.
Rising rates rattle bond markets in the short term
As a sign of long-term economic recovery, rising rates are unquestionably a good thing. With inflation in check, higher rates can favour competitive lending, reward savers, and provide retirees with more interest income.
But their re-introduction has disrupted pricing in the bond markets.
In general, when interest rates rise, bond prices fall. As rates go up, previously issued bonds look less attractive to investors in the resale market. Most Canadian bond indexes have posted negative returns this year to date — exactly as we anticipated would happen once policy makers began to lift monetary stimulus.
We've positioned MD funds and portfolios to ride out the waves, protect capital, and take advantage of global opportunities for fixed income investing.
Global diversification softens interest-rate transition
To prepare for this expected shift in the bond markets, we've been proactively adjusting MD fixed income funds and portfolios to protect capital.
We're maintaining shorter than benchmark duration positioning and are appropriately invested for a flatter yield curve—where short-term bond yields have increased by a greater amount than long-term bond yields.
While we continue to own mainly Canadian bonds (federal, provincial, municipal and corporate), we've also introduced globally diverse investments that are less sensitive to rising interest rates and can provide an additional source of returns.
Select fixed income investments may add risk-adjusted returns
We seek to add this risk-adjusted return through exposure to investments such as:
- Foreign bonds issued by countries or emerging markets less affected by rising interest rates and supported by solid market fundamentals.
- Higher quality bank loans comprised of debt from companies like Air Canada and Aramark, for example. These issues rank senior to other company debt for capital protection, bring additional income (often non investment grade) and can pay an elevated variable rate that benefits from interest rate increases.
- Exposure to high quality U.S. high yield bonds.
Stay invested to make rising rates work to your advantage over time
Rising interest rates present an opportunity for higher fixed income returns down the road, and we have appropriately positioned MD funds as well as our portfolios to mitigate risk and preserve capital through this market transition.
We continue to expect interest rates to be modestly higher with Canada's economic growth projected to be close to potential for the near future. For now, bond yields are still very low, but our diverse fixed income exposure aims to maximize total risk-adjusted return while preserving capital as prices adjust to the expected increase.
Rising interest rates create a challenging environment for fixed income investors, and will continue to mute returns in the short term. But you can have confidence that, over time, fixed income will continue to contribute positively to your portfolio and act as a means to reduce volatility overall.
Talk to your MD Advisor for more information on what we can do to manage market risks and why it's important to stay invested through all market cycles to realize investment goals.