The U.S. Federal Reserve is likely to start moving interest rates higher this month. Closer to home, the Bank of Canada seems to be on hold for the foreseeable future, given the continued weakness in the energy sector. Even with the Bank of Canada standing pat, we are likely to see an uptick in volatility in the bond markets, making the environment very challenging.
When rates do begin to rise, it will become increasingly difficult for fixed-income investments to generate any meaningful returns. In fact, it is highly likely we will see losses from bonds, depending on the speed and magnitude of any rate rises.
Estimating rate sensitivity
A great way to estimate the interest rate sensitivity of a fixed-income investment is to look at its duration. The higher the duration of an investment, the more sensitive it is to movements in interest rates. Because bond prices move in the opposite direction of interest rates, you will want to have a shorter duration if you expect that rates will move higher. This shorter duration will help to protect your capital better.
The point is that even modest increases in rates can create losses for investors, particularly those invested in longer term investments.
Strategies for protecting capital
In addition to shortening the duration of your fixed income holdings, there are a few other options to help protect capital in a rising rate environment. Here are some of the key things that I look for in a bond fund:
Low fees.With bond returns expected to be low for the near- to mid-term, you will want to reduce the impact of costs, keeping more money in your portfolio.
Active management.With an active fund, the manager can do things such as increase the yield, shorten the duration, and take advantage of other opportunities as they arise. They may also be able to invest in other strategies such as high yield, derivatives, and currency, which can provide additional return and also help protect you against major drops in value. Look for managers not afraid to take bets.
Higher yields.With yields expected to be the main driver of return for the near term, you will want to maximize them. As well, a higher yield can provide a better buffer against rising interest rates than lower yields.
Global bonds.Global bonds trade off of a different set of economic factors than Canadian bonds. By bringing some global exposure into your portfolio, you can provide an extra layer of diversification than what you can get with investing only in Canadian bonds.
Bottom line
Yes, the return outlook for bonds is muted at best, and downright depressing at worst. It is highly likely that most investors will see their bond investments post losses in the next little while.
But that doesn’t mean you should move out of bonds. On the contrary. Bonds have been, and should continue to be, an integral part of your portfolio. They can provide a tremendous safe haven in periods of uncertainty, and can help preserve the value of your portfolio when equity markets drop. However, as we move forward from here, bonds can no longer be counted on as a key driver of portfolio returns. Instead, their main role will be to help to reduce overall portfolio volatility in periods of uncertainty.
Courtesy Fundata Canada Inc. © 2015. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.
