Are You A Bond Investor? How Rising Interest Rates Affect You

What you should know as a bond investor.

It should come as no surprise the super low interest rate environment has made it challenging for Canadians to save for retirement.

Yet, while bond yields have dropped somewhat over the month of January, they have been trending higher over the long term. Rising interest rates generally mean higher returns for savers – but it’s important to be aware that these rising rates can pose a threat to your investment portfolio, especially if you’re invested heavily in fixed income.

Canadians Not Aware Of Rising Bond Yield Risks

Sixty per cent of Canadians with retirement portfolios are unaware of how rising interest rates can erode the value of their investments, according to a new poll from CIBC Asset Management. In fact, baby boomers who typically have a larger percentage of their portfolio in fixed income are mostly in the dark, with 65 per cent unaware of the impact of rising rates. Even more worrisome, 54 per cent of Canadians are not even considering changing their retirement savings strategy in a rising interest rate environment, with the figure jumping to 62 per cent for baby boomers.

The Bond Investor Basics

Before we discuss how bond yields work can impact your investments, it’s important to understand what exactly they are. A bond yield is the return an investor earns when they hold a bond until maturity. Similar to mortgage rates, typically the longer the term of a bond, the higher the coupon rate (interest rate). When you purchase a bond, you’re lending funds to the bond’s issuers – a company or the government – who makes a promise to pay the bond’s face value at maturity.

The Relationship Between Bond Yields and Bond Prices

Now that you have a basic understanding of bond yields, here’s your next important lesson: bond yields and bond prices have an inverse relationship – when bond yields go up, bond prices go down and vice-versa. Bonds are called fixed income for a reason: when you purchase a bond, its coupon rate is fixed. For example, you may purchase a bond with XYZ Company that offers a five per cent coupon, meaning you’ll get an additional five per cent of the bond’s value upon maturation.

Why Rising Rates Devalue Bonds

Let’s use your theoretical XYZ bond with five per cent coupon as an example and assume over the course of the year interest rates rise. In order to attract investors, XYZ Company increases its coupon rate to six per cent. For those investors holding five per cent coupons, their bonds are suddenly worth less. Why would an investor purchase a bond at five per cent when they can purchase a bond with a six per cent return for the same price? In order to sell, you’d have to offer your bond at a discount. If interest rates continue to climb, they can significantly devalue bonds currently held by investors. Those most at risk are bonds furthest from maturity and those offering lower yields.

Investment Strategies for Rising Rates

If you believe interest rates are on the rise, it’s important to be proactive and develop an investment strategy.

“Fixed income investments are bonds, as bonds are typically issued at a specific fixed interest rate, although there are some – a few – floating rate bonds,” says Dr. Ian Lee, a member of our Mortgage Rate Outlook Panel and former counsel to the government on monetary policy. “Normally, stable prosperous countries such as Canada and U.S. issue bonds at the lowest interest rate, called the ‘risk free rate of return’ as they cannot default. So the first advice is to look at buying blue chip corporate bonds, as they offer higher returns.”

You can also consider “floating rate” investments for added rising rate protection. Unlike traditional bond investments, the interest rate increases with benchmark rates. “This advice counsels investors to seek out bonds with a floating rate tied to the bank prime, so that as interest rates increase over time, the investor is protected as his return will increase as the bank rate increases,” says Dr. Lee.

Go The Shorter Route If In Doubt

As mentioned, the longer the term of bonds, the higher the interest rate risk. In a rising interest rate environment, you should look at bonds with shorter durations. The last thing you want to do is lock in for five years at a low rate, only to see interest rates rise.

“All bonds – government or corporate – are issued for a specific time .e.g. a one-year bond, a three-year bond, a five-year bond, a 10-year bond,” explains Dr. Lee. “The interest rate on that bond is locked in or contracted for the life of the bond. If the investor thinks interest rates will be going up, then buy much shorter bonds e.g. a one-year or three-year bond.  When the bond matures, the bond issuer pays you back the value of the bond.”

Related Topics

Growing Your Money / Savings / Savings News

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