Is your fixed income portfolio built to thrive when interest rates rise? Now is a good time to find out. After years of low borrowing costs, rates appear to be headed higher as the economy improves, inflation ticks higher and jobs become easier to find. Given this backdrop, here are a few suggestions on how to position fixed income in your portfolio:

 

Stick with short to intermediate bonds until higher yields are available on longer dated bonds. The yield curve is particularly flat, which means that there is not a lot of compensation for taking on interest rate risk right now. Longer dated yields should move higher in Canada over the course of the year, which would likely lead to these bonds underperforming short to intermediate bonds. Shorter-term bond yields already reflect expectations of higher rates as the market is pricing-in two and three additional 25bps rate hikes from the BoC this year.

 

Keep more of the yield on your bonds by purchasing discounted bonds. Buying bonds trading below $100 provides a more tax efficient fixed income return stream because more of the return comes in the form of a capital gain rather than interest income.

 

Don’t forget the correlation between equity and credit markets. In this buoyant environment, it’s worth reiterating that fixed income’s role in an investment portfolio is to provide stability and diversification. Riskier credit investments, including high yield bonds and preferred shares, have grown more popular over time and these strategies have positive long term correlations with equity markets. Investors should ensure they hold enough traditional fixed income investments in an effort to minimize sensitivity to equity markets as we move towards the latter stages of the business cycle. Upgrading quality in fixed income currently entails minimal opportunity cost.

 

There is still room for the preferred share market to recover from a decade of under-earning. The preferred market has significantly underperformed its 4.5-5% yield for the last decade, and although preferred shares look less attractive after a ~30% rally, they should continue to provide a long-term potential return of 4-6%. A tilt towards active management in this market would be prudent.