Understand interest rate risk and its impact on your future.
Understanding interest rate risk
Investors usually look to fixed-income investments to provide a safe haven from equity market fluctuations and to provide income and steady performance over time. However, investors need to be aware of the risks associated with fixed-income investments, particularly interest rate risk. With interest rates in Canada and around the world at historically low levels, and economic recovery on the horizon, there is a definite chance that rates could rise over the next few years.
What investors may not understand is that when interest rates do begin to rise, bond prices will go down (and vice versa).
How active management can help
These uncertainties do not mean that all fixed-income investments are equally susceptible to interest rate risk. There are a number of ways that active fixed-income managers can minimize the impact of a rising interest rate environment and still search out attractive opportunities.
For example, rising rates can have more of an impact on longer-duration bonds (i.e., bonds with a maturity of 10 or 20 years) than shorter-term bonds. Therefore, if expectations are that interest rates are going to rise, managers can invest in government or corporate bonds with shorter maturities (i.e., in the one- to five-year range).
Many bond types to choose from
Below are a number of options within the fixed-income asset class that can provide investors with potentially higher yields without sacrificing credit quality. Combining these options selectively will create diversification benefits and can safeguard against the impact of rising interest rates.
Corporate bonds: Rising rates are also seen as a sign of an improving economy and healthier corporate balance sheets – a time when corporate bonds tend to perform well. Many equities also fare well when the economy is in a growth phase. Exposure to corporate bonds tends to help mitigate some of the downward pressure on bond prices resulting from rising interest rates.
Floating-rate loans: Floating rate loans are attractive when interest rates are expected to rise because, as rates move higher, the bond’s interest payment (coupon) also increases.
High-yield bonds: High-yield bonds offer much higher coupons than investment-grade bonds and are less rate-sensitive since their performance is driven more by the underlying company’s health than interest rate movements. Keep in mind, though, that high-yield also entails greater risk than investment grade.
Inflation-linked bonds: Known in Canada as real return bonds, these bonds guarantee that an investor’s returns are not reduced by inflation because when inflation rises (a time when interest rates typically move higher as well), the bond’s principal and subsequent interest payouts also rise, so the real return isn’t impacted.
Global bonds: A wider universe of bonds can increase the diversification benefits within a portfolio by reducing volatility over time and can offer greater opportunities than solely investing in Canadian bonds.
To learn how you can diversify your fixed-income portfolio, talk to your financial advisor or visit AGF.com/Income.
The contents of this Web site are provided for informational and educational purposes, and are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. Please consult with your own professional advisor on your particular circumstances.