How changing interest rates affect fixed income

Get out of the interest rate guessing game to truly understand the risks of various fixed income investments and pick the best ones for you

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It’s been a tough few months for bonds. Since early February, the yield on Government of Canada five-year bonds has climbed from 0.59% to about 1.07%, and 10-year bonds yielding 1.24% have ticked up to 1.82%. The seesaw relationship between yield and price means bond values have fallen sharply: over the same period broad-based index ETFs such as the Vanguard Canadian Aggregate Bond (VAB) have lost well over 3%.

A 3% decline over several months is modest—it’s a bad day for stocks—but bond investors have been so accustomed to steady gains in recent years that it’s caused a lot of anxiety. More worrisome, it’s revealed that many investors have some fundamental misunderstandings about the relationship between bonds and interest rates, which admittedly can be confusing. Inaccurate information leads to poor investment decisions.

If the last five years have taught us anything it’s that forecasting the direction of interest rates is futile, and countless armchair economists have paid the price for trying to do so. A better approach is to get out of the guessing business and simply understand the risks of various fixed income investments. Then you can make a rational decision about which ones are appropriate in your situation.

It’s also key to appreciate that short-term and long-term risks may differ: avoiding the possibility of loss in the short-term, for example, often comes with the risk of lower long-term returns. That’s why investors with a long time horizon can safely ignore the “guru” on BNN who only cares about his quarterly results and not your retirement plan.

The following table should help you understand the effect of changing interest rates on different types of fixed income investments, in both the short term and the long term. Since you can’t know where rates are headed in the future, the best you can do is understand what to expect from your fixed home holdings under both scenarios.

If interest rates fall If interest rates rise
Short-term bond fund Short term: The price of your holding will rise. If the fund has a duration of 3, it would rise in price by about 0.3% if short-term interest rates decrease by 0.1% (10 basis points).

Longer term: With rates on newly issued bonds now lower, reinvested interest and proceeds from maturing bonds will quicklyhave lower expected returns going forward.

Short term: The price of your holding will fall. If the fund has a duration of 3, it would fall in price by about 0.3% if short-term rates increase by 0.1% (10 basis points).

Longer term: With rates on newly issued bonds now higher, reinvested interest and proceeds from maturing bonds will quickly benefit  higher expected returns going forward.

Broad-based bond fund Short term: The price of your holding will rise, and more sharply than short-term bonds. If the fund has a duration of 8, it would rise in price by about 0.8% if interest rates decrease by 0.1% (10 basis points) across the board. The fund will be sensitive to changes in 5-, 10- and 20-year bond yields as well as short-term rates.

Longer term: With rates on newly issued bonds now lower, reinvested interest and proceeds from maturing bonds will graduallyhave lower expected returns going forward.

Short term: The price of your holding will fall, and more sharply than short-term bonds. If the fund has a duration of 8, it would fall in price by about 0.8% if interest rates increase by 0.1% (10 basis points) across the board. The fund will be sensitive to changes in 5-, 10- and 20-year bond yields as well as short-term rates.

Longer term: With rates on newly issued bonds now higher, interest and proceeds from maturing bonds willgradually benefit from higher expected returns going forward.

Five-year GIC ladder Short term: Unlike with bonds, you’ll see no increase in the value of your GICs. However, you can take comfort knowing that your GICs have rates higher than those currently offered.

Longer term: As each rung of the GIC ladder matures, you will need to reinvest the proceeds at lower rates. The overall yield on your ladder will therefore gradually decrease.

Short term: Unlike with bonds, you’ll see no decrease in the  value of your GICs. However, you’ll have some opportunity cost, as your GICs will be locked in for up to five years at rates lower than those currently offered.

Longer term: As each rung of the ladder matures, you will be able to reinvest the proceeds at higher rates rate. The overall yield on your ladder will therefore gradually increase.

Cash Short term: Unlike with bonds, you’ll see no increase to the value of your cash account. Banks may lower the rates on savings accounts almost immediately.

Longer term: Cash is almost guaranteed to lose to inflation, and you will likely pay a high opportunity cost by avoiding bonds. If you were sitting in cash waiting to get back into the bond market, it backfired: the cost of doing so will be higher and expected returns  lower.

Short term: Unlike with bonds, you’ll see no decrease to the value of your cash account. Banks may raise the rates on savings accounts.

Longer term: Cash is almost guaranteed to lose to inflation, and you will likely pay a high opportunity cost by avoiding bonds. However, if you were sitting in cash waiting to get back into the bond market, you got lucky: the cost of doing so will be lower and expected returns higher.

This article originally appeared on Canadian Couch Potato

3 comments on “How changing interest rates affect fixed income

  1. I am a conservative person and have 1-7 year GIC’s, term deposits, cashable GIC’s. I have averaged about 3.5% over the last 6 years. I am now looking at strip bonds.

    The reason I am doing this is I need an investment that I can hold to with a fixed rate of interest that compounds and I can keep until maturity, no matter what interest rates do.

    Today, the best GIC rates at around 2.5% to 2.65% for 5 years. They are much lower than in the past 6 years. The best I have found and just bought this week is a Manitoba 2032-September-5 with a 3.37% yield to maturity. This includes commission in case anyone is wondering.

    Basically, my $10,000 investment matures at $17,773 at maturity so $7,773 is the total interest or $450 a year interest. I was looking at past rates and 4.00% to 4.5% is a more average rate but I don’t know if we will see these rates come back and stay at those higher rates.

    Reply

    • Tina, I understand what you are concerned about with low GIC rates right now. I had 4% to 4.5% GIC’s just 6 to 7 years ago. I am 32 years old and have been investing in RRSP’s and TFSA’s for years now.

      I got some provincial strip bonds back in 2007, 2008, 2009, when they were 4.8%, 4.7% yields. I don’t see them going to more than 3.7% in the next 12 months at least.

      As you stated in your above post, you want a fixed rate investment that compounds for many years that are paying more than 5 year GIC’s. The last time I bought them was back in 2013 at 4.1% yields so maybe we will hopefully see those again.

      Reply

      • Tina and Jessica, I just invested my $10,000 TFSA contribution today in a corporate strip bond, Canadian Tire Corporation, 2034-February-24 4.40% yield to maturity, YTM all commission included.

        My $10,000 will be $22,951 at maturity. I have other provincial strip bond and Canada strip bonds in my RRSP’s, TFSA’s, RESP’s that I have invested for years.

        I remember and still have 4.7% to 7.4%, government, corporate strip bonds that still have 8 to 13 years left to maturity that I purchased back in 1998, 1999, 2000, 2001, 2002, 2004, 2005, 2008, 2009, 2011, 2013.

        Reply

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