Protecting Your Portfolio From Rising Interest Rates
The Bank of Canada has increased interest rates twice since July and many are anticipating one or more hikes before the end of the year.
Investors need to consider how rising interest rates might affect their portfolio.
Rising Interest Rates and Inflation
The effect of inflation on savers and investors is the loss of purchasing power. This is especially important for retirement savings as contributions are made today to provide income in the future. For example, if annual inflation is 2%, in just ten years investors will have to withdraw almost $122 from their RRSPs to purchase the same products that cost $100 today.
Fortunately. there are a few strategies you can use to help protect your investments from rising interest rates and inflation.
1. Bonds
With your bond holdings, maintain a short duration (three to five years) to minimize the impact of rising rates. Longer term bonds don’t offer much greater returns but they do have a greater interest rate risk which ends up decreasing the price.
Real Return bonds are worth considering when inflation is expected to rise. They guarantee that returns are not reduced because the bond’s principal and subsequent interest payments are adjusted to reflect changes in inflation.
e.g. iShares Canadian Real Return Bond Index ETF (XRB)
2. Preferred Shares
More investors are reconsidering preferred shares as a fixed income alternate. Rather than researching individual preferred shares – with all their complicated features – use ETFs which provide easy access to this asset class.
Rate-reset preferreds have a five-year time frame, and as the name suggests, the interest rate is then reset.
e.g. BMO Laddered Preferred Share Index ETF (ZPR)
Another class of preferreds includes a floating rate feature whereby the dividends are set by a pre-determined formula. They will increase their dividends are rates increase.
e.g. Horizons Active Floating Rate Preferred Share ETF (HFP)
3. REITs
REITs own or operate income producing real estate such as offices, residential, retail, industrial, hotels and senior living residences.
Real estate is a natural inflation hedge because rents and values tend to increase when prices do.
e.g. Vanguard REIT ETF (VRE)
4. Equities
As interest rates rise, bond yields might start to look more attractive, which could cause investors to stampede out of dividend paying stocks and into fixed income for the lower overall risk.
However, history has proven that returns of stocks exceed the rate of inflation over time. Over the past 20 years, the average inflation rate in Canada has been 2% (Statistics Canada), while the average annual performance of the S&P/TSX Composite Index was 11% (Bloomberg).
Dividend paying equities offer continuous and stable returns. Focus on blue-chip companies such as banks, pipelines, telecoms, resources, and non-discretionary consumer, that continually raise their dividends, such as the “Dividend Aristocrats.”
e.g. iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ)
iShares US Dividend Growers Index ETF (CUD)
Final Thoughts
We’re not likely to see signs of rampant inflation (as in the late 1970’s) in the near term, but inflation has an important impact when we try to determine financial needs far into the future.
Since retirements are now expected to last at long as 30 years or more, inflation can cause a serious cash flow shortfall at a time when there is little ability to change the outcome.
It may be a good time to consider if your portfolio is properly protected. Using a combination of these strategies can lessen the impact of rising interest rates.
I personally disagree with quite a few points in this article:
1. It seems like the 4 options: bonds, preferred shares, REITs and Equities are equally viable options. They aren’t. The risks are all very different. Bonds are the safest, followed by preferred shares then REITs and Equities. Also, preferred shares should only be used in non-registered accounts for their tax efficiency, but are not a completely legitimate alternative to bonds because of their increased risk.
2. “Longer term bonds don’t offer much greater returns but they do have a greater interest rate risk which ends up decreasing the price.” Longer bonds have greater returns. The returns are commensurate with the additional risks. The rule of thumb with bonds is that the duration should not be longer than the length of time you hold them, but if you are holding them for 10+ years, longer term bonds are not bad.
Also, this is the classic example of thinking you know more than the market. The likeliness of increased interest rates are already included in the price of bond funds. People have been worried about bonds for more than 5 years now and have been wrong for 4 of those years.
3. Real return bonds in Canada are generally long term, so have a very high volatility. Shorter term bonds are much safer.
4. REITs – REITs are expected to drop with increased interest rates because these companies have mortgages and loans on properties, so they loose when interest rates go up. They aren’t a good hedge against increased interest rates – quite the opposite.
5. Dividend stocks are stocks so they are risky. Companies cut their dividends sometimes. They are not a reasonable alternative to bonds when it comes to safety.
My personal opinion on the matter is that all the public known information is already incorporated into the value of the stocks and bonds. No matter what you expect in the future, timing the market and adjusting your investments based on your short term predictions has almost always been shown to be a bad idea. You are best off keeping a well diversified portfolio with the appropriate allocation of stocks and bonds based on your need, willingness and ability to take risk. Don’t sell when something under-performs, just re-balance once a year. This has historically been shown to be the most prudent way to invest.
Surprisingly, there are a lot of conflicting opinions on this topic. I chose what makes the most sense to me based on my experience – not just theory.
I find it interesting that you have made assumptions about points not indicated, or even implied, in the post and have chosen other statements out of context to make your own points.
Anyway, thanks for your comments and opinions.
EngPhys, I agree with you, although bonds longer than 10 years should probably be avoided as they have more risk than return. A 10 year government bond ladder, (or it’s fund equivalent, an intermediate term government index fund or ETF), is the sweet spot balancing interest rate and reinvestment risk, and is good solution for those whose time horizon is 6 years or longer, the duration of the fund. A total bond ETF is also a good choice although it has a small allocation of long term bonds. It is a mistake to buy short term bond funds just because you think interest rates are going to rise. The yield curve is the best predictor of future interest rates, and expected future interest rate changes are baked into it. You will only do better with short term bonds if interest rates go up more than expected, and worse if interest rates behave as expected or go down. You are better off choosing a bond fund in line with your time horizon and stay the course through the temporary price drops that will occur when interest rates rise. Hold for the duration if the bond fund and you get your money back, due to higher yields of the new bonds from the proceeds of the maturing bonds.
Hi Grant. Thanks for your comment. I agree that a bond fund would make the most sense for most bond investors – durations are usually in the 5 – 7 year range.
You say you agree with EngPhys about choosing long-term bonds – and then you disagree with him by stating 10 year terms are best 🙂
Who anticipated that interest rates would have 2 increases in the space of 2 months when there were none in the past eight years?
What’s the best fixed income approach in a taxable account? I have all my fixed income in cash in my savings account because I’m not confident where to put it.
Hi Jeremy. The most tax efficient investment income is dividends -from equities or preferred shares. However, there is a real risk of your principal losing value. Bond funds can also drop in price. If this risk is not acceptable to you, or you can’t afford to wait out a drop in the market, you would be better off with GICs and individual bonds, laddered for different maturities as Grant (above) suggests, and hold them until maturity. Even if you are taxed 30-40% on the interest, you will still end up with a better return than leaving your cash in a savings account.
Jeremy, the other option for fixed income in a taxable account is a tax efficient premium bond ETF like ZDB, or the swap based fund HBB which is also very tax efficient, or BXF a strip bond ETF. Don’t hold regular bond ETFs such as VAB in a taxable account due to tax inefficiency when held in these accounts. If you want price stability a 5 year GIC ladder is the best option and usually has higher yields than bond funds. Buying individual bonds is not usually recommended for DIY investors due to lack of transparency in the bond market resulting in high and opaque mark ups in prices. I’m told that you need a bond portfolio north of $500k to make constructing an individual bond ladder cost effective, probably with professional help
Hi Marie. Sorry, perhaps I wasn’t clear, but what I meant was I agree with EngPhys except for him appearing to favour long term bonds (bonds with a term longer than 10 years). I didn’t mean that 10 years terms are best – I meant a 1-10 year bond ladder (therefore average term 5 years) is a good option, or it’s fund equivalent an intermediate bond fund or total market fund.
I agree that when it comes to fixed income experts don’t agree on the optimal strategy, and as is often said on Bogleheads, “when experts don’t agree, whichever strategy you choose doesn’t really matter”