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.
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)
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)
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)
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.