Interest Rates are on the Rise but so are Future Returns

November 18, 2016

By Wesley Blight, CFA, CIM, FCSI
Portfolio Manager, Fixed Income

Earlier this week, when some of the big banks started raising rates on mortgages and other loans, I tried hard to sound empathetic as my friends and colleagues complained about their soon-to-be higher borrowing costs.

I also recognize that recent returns from fixed income have been negative but honestly, I welcome higher interest rates. As consumers, we’ve grown accustomed to the benefits of low interest rates. The problem is, we don’t necessarily understand the negative economic implications of a low interest rate environment, especially over the very long term.

So why am I happy about rising rates?

Think of the bond market as a predictor of the economy—it’s the closest you can get to a crystal ball. As interest rates rise, the bond market is trying to tell us that we should be optimistic about the future direction of the economy.

The recent rise in interest rates is a direct result of Donald Trump being elected president. A portion of Trump’s campaign was focused on infrastructure spending, tax cuts and renegotiating trade agreements—all of which are intended to stimulate the U.S. economy. But with higher growth, we can also expect higher inflation and thus higher long-term interest rates.

In Canada, long-term interest rates have historically moved in tandem with its U.S. counterparts and I think this makes good sense. If the U.S. economy improves and grows, it will affect Canada directly. After all, we have been and expect to remain a very important trading partner.

That said, the short-term impact of higher interest rates is likely to be painful. As rates rise, borrowers will face higher costs and I expect fixed income investors will experience short-term losses on their bonds and bond funds.

However, I fully expect most bonds and bond funds will recover in a relatively short time. As long as a bond doesn’t default, I expect it to move toward its face value as it approaches maturity. Thanks to our deep credit research in both Canadian and foreign bonds, I am confident that the holdings we have chosen for our MD funds and portfolios will stand the test of time.

Through the rest of this year and into early 2017, I expect interest rate and capital market volatility to continue.  However, our Canadian-focused, but globally diverse bond funds are positioned for higher yields (and greater breadth). I will continue to be prudent about how we manage risk in our bond funds, given the current interest rate environment. 

My goal is to mitigate the short-term impact from rising rates, without having to seek out higher-yielding, lower quality investments. In other words, I’m looking to position our clients for a smoother ride with less downside risk.

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