Watch interest rate risk

Most people benefit if they make a correct projection with respect to the direction of interest rates.  This is easily illustrated when you are deciding on the type of mortgage.

If you feel interest rates are going down, or are staying close to current levels, then the best option is likely a variable rate mortgage.  If you feel interest rates are going up in the near term, then locking in with a fixed rate mortgage may save you interest costs over the term.

Central banks in the United States and Canada announce changes to interest rates on predetermined dates.  In Canada, there are eight specified dates during the year.  Central banks also retain the option of taking action between fixed dates, although they would exercise this option only in the event of extraordinary circumstances.

By the time the predetermined dates arrive, most economists have a pretty good idea what the current change will be.  What is really important is listening to the words of the U.S. chairman or Canada’s governor say with respect to economic conditions and the outlook for future interest rate changes.

One of the most interesting components of macro-economics deals with monetary policy, inflation, and interest rates.  When central banks are looking to stimulate the economy, interest rates are lowered.  This should encourage more borrowing and spending.  When the economy is growing too quickly, or inflation concerns are rising, raising interest rates helps slow down the growth.  Interest rate changes are generally tied to economic conditions.  If conditions are improving, interest rate increases are more likely.  If deteriorating then interest rate cuts (if possible) are more likely.

So how does all this economic jargon impact investors?  Some investments are more likely to fluctuate in value than others as interest rates change.   We have illustrated a few scenarios below:

Bonds versus Equities

Bond prices change inversely to fluctuations in interest rates.  If rates go down, existing bond prices rise.  If rates go up, bond prices decline.  Interest rates are at historic lows now.  As rates go up, the price of your existing bonds may decline in value.   If interest rates are increasing, that is generally a sign that the economy is improving.  If the economy is improving then investors are generally better off in equity investments.

Short Term versus Long Term

Investors with low tolerance for risk should always hold a majority percentage of fixed income type investments (bonds, Guaranteed Investment Certificates, term deposits, deposit notes).  What should fixed income investors do if they feel interest rates are likely to change?  If you feel interest rates are likely to increase then the focus should be on short-term maturities, being five years and under.  If you feel interest rates will decline over the long term then you may profit from extending your maturity dates beyond five years.  All investors should look at the maturity dates of their bonds.  If all of your bonds are long term and interest rates begin increasing, then you will likely see a decline in the value of your long-term bonds.  The benefit of bonds is that they may be sold at anytime and the proceeds used to purchase other bonds with different maturity dates.  The number one thing to note is that the longer the duration (time to maturity) the greater the volatility when rates change.

Preferred Shares

If you own preferred shares, determine what type you own.  Not all preferred shares are created equal.  Hard retractable preferred shares have a set maturity date and fluctuate less with changes in interest rates.  Perpetual preferred shares mean they have no legal maturity date and are very susceptible to changes in interest rates.  If interest rates begin to climb then you should expect the value of this type of preferred share to decline in value.  The higher the coupon on the perpetual preferred the less volatile it will be to changes in interest rates.

Call Features

Unfortunately most call features benefit the issuer, rather then you, the investor.  When an investment has a call feature you should monitor the call dates and the likelihood of it being called.  Structured products, fixed income (Tier 1 and Tier 2), and preferred shares are examples of investments with call features.  In some cases, the market anticipates the investment to be called.  It is best to speak with your advisor about whether your investments have call features.

Timing and Magnitude

Interest rates are currently at historic lows in the United States and Canada.  Timing of course is the toughest part when it comes to projecting interest rate changes.  Even if one is confident in the direction of interest rates, it really comes down to further projections.  When will they change?  How fast will the change occur?  What will be the magnitude of the changes?

We recommend you discuss how your portfolio may fluctuate with changes in interest rates.  By looking at the probability of different outcomes you will be able to map out a plan to minimize interest rate risk.