The impact of rising rates

Market Insights: October 24, 2016 • Interest rate risk
 

“What normal looks like today is different than it’s looked in the last 20 or 30 years. I believe that interest rates will probably be moving up in the U.S. to about 1.8% by the end of this year and about 2.7% by the end of next year.”

— Dan Bastasic, MBA, CFA
Senior Vice-President, Investments iA Clarington Investments

“We’re likely in an environment where interest rates don’t keep going down. And if all of a sudden yields start to bubble up, which I believe is a reality we’re all going to have to face soon, those who are holding bonds that are interest rate sensitive may be negatively impacted.”

— Jeff Sujitno, HBA, CPA, CIM
Vice-President, Investments iA Clarington Investments
 

Interest rate risk: Traditional fixed income may be more vulnerable than in the past

Investors seeking income have traditionally turned to investment-grade bonds for the relative stability and conservative return profile that they can offer. And for much of the past 30 years, this asset class rewarded investors with reasonably attractive yields, plus the added benefit of potential price increases due to the long-term trend of falling interest rates (Chart 1).

But for the foreseeable future, investment-grade bonds may no longer provide the attractive total return profile that investors relied upon in the past. That’s because historically low rates on investment-grade bonds present two current challenges for traditional income-seeking investors. The first is that yields currently provided by investment-grade bonds may be insufficient to meet an investor’s cash-flow requirements, let alone outpace inflation.

Chart 1: Historic decline in interest rates helped drive total return in bonds

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Source: Bank of Canada, September 30, 2016.

Chart 2: Investment-grade fixed income could be challenged if rates rise

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Source: Bloomberg, September 30, 2016.

The second is the risk of a decrease in bond prices due to a potential increase in future interest rates. Even a relatively modest rate increase could significantly affect the price of a bond, putting invested capital at risk (Chart 2). For example, a 1% increase in rates would see an almost 9% decrease in the price of a 10-year Government of Canada (GOC) bond. For a 20-year GOC bond, the decrease would be over 14%, and for a 30-year GOC bond, the loss would increase to 20%.

The examples above illustrate the current interest rate risk associated with investment-grade bonds, which are more vulnerable to rate increases than in the past. This is due to the fact that bond yields are now lower, providing less income return while having a higher duration (Chart 3), which translates to greater interest rate sensitivity.

Chart 3: Interest rate sensitivity has increased

Total return comparison of investment grade bonds, 1994 vs. 2016

Jan. 31, 1994 Sept. 30, 2016
Yield to maturity (A) 6.02% 1.71%
Average coupon 9.23% 3.56%
Duration (years) 5.38 7.71
Price impact of a 100 bp yield increase (B) -5.38% -7.71%
Total return estimate (A+B) +0.64% -6.00%
The average coupon has declined, resulting in higher duration. This higher interest rate sensitivity combined with lower income return has reduced the total return potential of investment-grade bonds.

Source: PC Bond, a business unit of TSX Inc. Based on FTSE TMX Canada Bond Universe Index. This chart is intended to show the impact of a 100 basis point (1%) increase in yields. Total return estimate = yield to maturity + price impact of a 100 basis point increase.

 

Help reduce the risk

By diversifying sources of fixed income and moving into asset classes that behave differently and feature lower interest rate sensitivity (duration) and higher yield potential, investors can aim to lessen the impact of rising rates. Senior loans and high-yield corporate bonds are two alternatives that currently offer attractive levels of income potential relative to interest rate risk (Chart 4). When actively managed, each can play a role in a well-diversified income-oriented portfolio.

Chart 4: Yield and interest rate sensitivity

chart

Source: Bloomberg, Credit Suisse and PC Bond, a business unit of TSX Inc. (September 30, 2016). Indexes used: Canada bond universe represented by the FTSE TMX Canada Universe Bond Index; investment-grade corporates represented by the FTSE TMX All Corporate Bond Index; Canadian governments represented by the FTSE TMX All Government Bond Index; senior loans represented by the Credit Suisse Leveraged Loan Index; high-yield bonds represented by the BofA Merrill Lynch High Yield Master II Index.

 

To help mitigate the risk of rising interest rates, diversify your clients’ income portfolios with an active solution. Consider:

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Dealer use only . Statements by the portfolio manager or sub-advisor responsible for the management of the fund’s investment portfolio, as specified in the applicable fund’s prospectus (“portfolio manager”), represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Statements that pertain to the future represent the portfolio manager’s current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein.
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