After experiencing more than thirty years of falling interest rates from the highs seen in the early 1980s, we can be forgiven for forgetting that rates can actually go the other direction. After Canadian bond yields bottomed in February, 2016, they have been pushing back upward to levels that we haven’t seen in many years. As in all things investing, there are winners and losers in an investing environment where interest rates and bond yields are moving upward.
Let’s first try and simplify the difference between interest rates and bond yields. Interest rates are easier to understand as these levels are generally set by the government or banks. Without getting too deep in the weeds, the Bank of Canada sets the bank rate. The major banks take cues from that decision and set the prime rate of interest – the rate that they charge on variable-rate loans.
Bond yields are not set like interest rates. Bond yields are determined or derived by the movement in the price of a bond. Generally speaking, if interest rates are moving up in the market, bond prices tend to fall (bond yields move up), that is the fixed rate of interest that a bond pays looks relatively less attractive as interest rates in the market move up. As interest rates move down in the market, bond prices tend to rise (bond yields move down), that is the fixed rate of interest that a bond pays looks relatively more attractive as interest rates move down in the market.
Winners in a rising rate and yield environment are few and far between and tend to include any investment that pays a floating rate of interest or has a feature that resets the rate paid on a set timeline. Three fixed income examples include:
• Rate-reset preferred shares – This type of preferred share generally has a reset every five years wherein the issuer can redeem the shares at par (usually $25) and essentially end the investment or can extend the life of the preferred for another five year term at a new dividend rate. The new dividend rate is arrived at by adding two numbers together – the reset level offered by the investment when first issued (not subject to change) added to the current Government of Canada 5-year bond yield. It is the second part of that equation that makes them respond well to rising bond yields, as the new reset rate will be higher when the 5-year Canada bond yield is moving up. These also benefit from the preferred tax treatment of Canadian dividends.
• Floating-rate preferred shares – This type of preferred share adjusts the level of dividends paid with changes in the prime rate of interest. As the prime interest rate goes up, so too does the income paid. These also benefit from the preferred tax treatment of Canadian dividends.
• Floating-rate bonds – These floating-rate bonds or notes have a variable coupon and provide an important source of liquidity for companies. A very large market, particularly in the United States, has led to several mutual fund companies now offering floating-rate bond funds.
Losers in a rising rate and yield environment tend to include most bonds and bond funds. The stock market generally doesn’t like rising rates and yields either, though commodity-type companies tend to benefit from the price inflation that usually accompanies this environment. Government bonds in particular, with their lower interest rates or coupons, tend to drop in price more than corporate bonds that pay higher rates of interest. This explains why that bond you hold in your portfolio or bond mutual fund has recently been falling in value. Keep in mind that this sensitivity to rising rates needs to be weighed against the principal protection offered by government bonds.
Securities or investment strategies mentioned in this newsletter may not be suitable for all investors or portfolios. The information contained in this newsletter is not intended as a recommendation directed to a particular investor or class of investors and is not intended as a recommendation in view of the particular circumstances of a specific investor, class of investors or a specific portfolio. You should not take any action with respect to any securities or investment strategy mentioned in this newsletter without first consulting your own investment advisor in order to ascertain whether the securities or investment strategy mentioned are suitable in your particular circumstances. This information is not a substitute for obtaining professional advice from your Investment Advisor. The commentary, opinions and conclusions, if any, included in this newsletter represent the personal and subjective view of the investment advisor, Kevin Hazzard, who is not employed as an analyst and does not purport to represent the views of RBC Dominion Securities Inc.
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