I have noticed a trend! As fall moves into winter everyone’s mind has turned to inflation and interest rates. A perfect time to revisit the impact of increasing interest rates on an investment portfolio, specifically the fixed income allocation.
Typically we look to those “fixed” securities to provide flexibility, a stable income stream and ideally lower volatility than we can expect from our equity holdings. Our focus has always been on credit rating, yield, and of course, the term to maturity. Credit rating is most important as we want to be sure that whoever we lend money to….can pay it back! The more risk you take the higher the income. We try to find a place to stand that is moderate risk such as Banks, Telco’s and Life Insurance Companies. These firms have large balance sheets, long time horizons and very good track records. The yield on this type of security is higher than a Government Bond or GIC but lower than most other commercial credit. The wild card is duration. The length of time that we would want to commit to any borrower. This is where inflation and interest rates enter into the equation.
Imagine that you have $100’s to loan out and the prevailing rate of interest is 3%. If interest rates rise to 5% and you are committed to a 3% deal with no opportunity to renegotiate, your loan value is going to shrink. Any new investor would demand 5% and you would have to make up the difference by discounting your note to the level that is required to meet the prevailing rate i.e. the $100 note is now worth $98. The same thing happens in your investment account and the impact is magnified by the length of time to maturity. Something very short –say under 5 years – likely changes very little in capital value whereas a 30 year note could change considerably more depending on how large a gap the interest rate increase creates.
To counter this and minimize the risk to capital we have moved to shorten the interest rate duration of the overall fixed income allocation thus minimizing the effect of rising interest rates on capital. That doesn’t mean that we want to throw away solid payers who are yielding a nice margin over current or anticipated interest rates but rather balance that exposure with much shorter term holdings. The end result is fewer long positions and more short to medium term holdings that we will reinvest into a higher interest rate environment should that materialize.
Livingston Wealth Management Group