Fixed Income In A Low Interest Rate Environment
Wain Stushnoff - Feb 29, 2016
Remember the days of double-digit returns on guaranteed fixed income products? At one point, it may have been prudent to weigh your portfolio in favour of "risk-free" fixed income investments to take advantage of skyrocketing interest rates. In 1981, a Canada Savings Bond had a guaranteed return of 19.5 percent, which seems almost too good to be true by today's standards (of course, inflation was also significantly higher during this time)!
Historically, investing in bonds has been an effective way to diversify risk in a portfolio. Although current interest rates are at record low levels, this doesn't mean that investors should abandon the strategy of allocating part of their portfolios to fixed income investing.
Why are Interest Rates So Low?
As a result of ongoing financial market uncertainty and slower economic growth, the central banks of Canada and the U.S. have been holding their key interest rates at low levels to try and stimulate growth.
When Will Bond Yields Rise?
Unfortunately nobody can predict when yields will rise. In the U.S., the Federal Reserve is expected to raise interest rates in the shorter term. The Bank of Canada lowered its target rate twice in 2015 due to persistently low oil price and commodity prices which have created a slow growth environment for our nation.
However, as the economic situation improves, rising interest rates are inevitable. If an investor has purchased bonds with long maturities and interest rates rise, the face value (or price) of the bonds will decrease. As interest rates rise, there may be better opportunities to purchase bonds with higher yields, but if existing bonds are replaced prior to maturity, these bonds would end up being sold at a discount.
How Does Fixed Income Fit Into My Portfolio?
Fixed income investments still play an important role in providing diversification to mitigate the volatility of stocks. In this low-rate environment, a fixed-income allocation strategy should consider other forms of fixed-income products, not just traditional bonds. This will allow for the potential to generate better income, while still balancing equity volatility and providing portfolio diversification. Here are some things to think about:
• Capital Preservation — Government bonds may be a reliable way to preserve capital during uncertain times. Cash isn't a good alternative as low rates of inflation have the potential to erode any small interest returns. Even modest bond returns may often be better than holding cash.
• Time to Maturity — The longer the time to the bond’s maturity, the greater the opportunity for interest rates to change. A 15- or 30-year bond may appear attractive today with comparatively higher yields than one with a shorter time to maturity, but it is difficult to predict how interest rates will affect the bond over this longer time period.
• Risk — Higher-risk fixed income securities often offer higher returns. For instance, a bond with a greater risk of default may offer higher interest payments. In the current rate environment, investors may wish to evaluate their risk appetite to improve income potential. Preferreds, corporate bonds or high-yield bonds may be suitable considerations, depending on risk tolerance. A bond fund or exchange-traded fund may help to diversify some of the risk depending upon the underlying fixed income securities. There are many fixed income alternatives available and we can offer recommendations depending on your risk profile.
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