By Tom Bradley

Interest rates have a profound effect on portfolio returns. The level of rates sets a base for on-going income and changes in rates affects security prices. As rates drop, bond prices rise and vice versa. The 25-year bull market for bonds and stocks that ended in 2007 was fueled by steadily declining interest rates.

Today, we are looking at quite a different scenario. Income generation is low and instead of the tail wind that most of us have experienced throughout our investment careers, we need to prepare for a head wind. Rates are at rock bottom levels and have nowhere to go but up.

As with The Hard Questions - Part I: The U.S. Dollar, I’m not here to take a stand on interest rates and inflation, but rather to address what steps investors can take to protect themselves in the event that rates rise. I lump inflation and rates together because they are inextricably linked. If government spending starts to push inflation up, investors will demand higher bond yields and rates will rise. If, on the other hand, high unemployment and excess capacity in the economy keep inflation pressures subdued, then rates may stay low for a while longer.

How do you protect your portfolio from rising rates?

  • Stay short. Longer-term bonds are more sensitive to interest rate changes and will be impacted the most by rising rates. If the yield on a 10-year bond goes from 4% to 6%, the price would drop approximately 15%, while a 3-year would be down only 5-6% if rates rose to a similar extent. High-interest savings accounts and 1-3 year GICs provide good protection.
  • Corporate bonds. Corporates are also impacted, but rising rates would likely mean that the economy is improving. So while the interest rate impact would hurt, the reduction of credit risk (default) would help to offset it.
  • Real return bonds. There are some government bonds that are inflation protected. If the Consumer Price Index (CPI) rises, the capital value of the bond is adjusted accordingly.
  • Companies with pricing power and growing dividends. It’s a bit of motherhood, but owning growing companies that are able to pass on price increases is a good thing. It provides some cushion against the reality that rising rates lower valuations on stocks by pushing yields up and price-earnings multiples down.
  • Gold. The list wouldn’t be complete without gold. It has always been viewed as a hedge against inflation. It may be, although I find it difficult to determine what drives the gold price at any given time.

Clearly, there is no free lunch here. Owning short-term bonds is defensive, but their income is modest at the current time. A diversified portfolio of corporate bonds and equities (such as our Income Fund) is a good alternative, but it must be recognized that you are taking more risk and subjecting yourself to some short-term volatility. And RRBs provide peace of mind, but yields are modest here too and they are expensive - the purchase price is assuming future inflation of 2.5% while the CPI is currently closer to zero.

Investors need to keep inflation in mind, but to repeat what I said in the U.S. dollar post, you never know what’s going to happen for sure. You can protect yourself against rising interest rates, but you’ve got to balance it off against your long-term goals. Further, keep in mind that fund managers often have an interest rate/inflation strategy that is reflected in their portfolios and they may therefore be duly protecting you from the impact of rising rates. The manager of our Income Fund, for example, pursues an interest rate anticipation strategy when managing the bond portion of the portfolio.

As always, pursuing any of the strategies above should be done in the context of your long-term investment plan.