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Table of Contents
Put your financial adviser on a leash
February 11, 2000
100% Foreign content for your RSP
December 22, 1999
Tax Loss Selling or Dealing With Your Mistakes
November 26, 1999
Life Stages of your RRSPs
November 12, 1999
Just give me boring (but great) rates of return
November 3, 1999
De-mystifying Demutualization - part Two
October 25, 1999
De-mystifying Demutualization - part One
October 19, 1999
Seg funds for the simple minded
September 14, 1999
The interest rate game Part 2
August 12, 1999
The interest rate game Part 1
July 30, 1999
Choosing funds: Five for the long run
July 14, 1999
New Funds: To buy or not to buy
July 2, 1999
Making sense of momentum investing
June 18, 1999
Rating the fund managers
June 4, 1999
Resource recovery hinges on supply and demand
April 30, 1999
Tech funds draw strength from favourable trends
March 24, 1999
Withdrawing from your RRSP
March 9, 1999
The economic implications of the euro - An interview with Ranga Chand
February 12, 1999
Underperforming small-cap funds have strong upside potential
January 29, 1999
How to pick a winning equity fund portfolio
January 15, 1999
View the Weekly Insight archive
   

The Interest Rate Game: Part Two

RICHARD WEBB AND LEVI FOLK
Friday, August 13, 1999

Last week we took a look at how interest rates affect equity funds and how an investor can benefit from a basic understanding of the effects of interest rate changes on financial markets. This week we look at the effect of interest rate changes on fixed income securities.

First, a brief recap of the basics, as we described them last week:

  • Short-term interest rates are closely linked to economic growth, consumer spending, borrowing, inflation, job creation, and bond prices. The Bank of Canada has the power to influence short-term interest rates and it does so when there are signs of upcoming inflation. In the past decade, the government has made it a policy to keep inflation below 3%, maintaining that this is a necessary condition for the country's continued economic growth and financial stability. Inflation in Canada has been below this official ceiling of 3% for the past few years, and the budget deficit has been eliminated, so there is much less motivation for the government to raise interest rates right now than in the past.
  • Inflation fighting in the form of rate hikes by the Bank of Canada results in a chain of events. Borrowing becomes more costly for banks, who in turn raise their existing interest rates until ultimately it is more costly for consumers and businesses to borrow. The end result, the economy slows, job creation idles and inflationary pressures subside.
  • Government and corporate bonds are affected by changes in short-term interest rates. A bond is a debt created by a government or corporation that has to be repaid, with interest, in a specified time. It usually has two components: the principal investment and an interest-bearing coupon. The price of the bond is determined by the market and is based on the face value of the bond at maturity, and the value of all the coupons (interest payments) that the bond holder is entitled to receive until then. Changes in interest rates make existing bonds more or less competitive in the marketplace.
  • If a rate hike by the Bank of Canada affects short-term rates directly, why is it that long-term bond prices sometimes move far more than short-term ones? The answer has to do with inflation expectations. Governments move short-term rates to combat inflation and fixed income investors react to the changes by affecting longer-term yields. The standard tool for visualizing this relationship is called a yield curve.

The yield curve shows the market's current yields for all fixed income securities, from 30-day treasuries to 30-year bonds, plotted on a graph. The yield curve usually looks like the path of a baseball from the point it hits the bat to the point it lands on the second deck for a home run. That is, longer dated bonds typically have a higher yield than shorter dated ones. If a rate hike by the Bank of Canada is perceived to be a fight against inflation that was orchestrated by a conductor who isn't keeping time, (i.e. it was too late to stop inflation), then bond investors will react by selling bonds.

Investors with long-term bonds stand to suffer most from a higher inflation, compared to bearers of short-term bonds because they are entitled to more coupon payments. Higher inflation erodes the value of those coupon payments far into the future, so investors will deem the long-term bonds to be worth less and they will lower their price, which is essentially the flip-side of a rising bond yield (the coupons divided by the price).

Since perception rules the bond markets, a rate hike that is believed to be unnecessary or, more to the point, recessionary, could cause bond prices to rise instead of fall. Since inflation is the irritation of the bond market, a rate hike that threatens to kill inflation is looked on with side grins by the bond market. Again, long-term investors are affected most. This time they have the most to win. So, long bonds will rise in price because yields will fall: investors need less of a buffer against the erosive inflation On the other hand, corporate (or high yield) bonds are also affected by rate hikes but this time in a contrary fashion to government bonds. What matters most about corporate bonds -especially high yield bonds (junk bonds) - are the companies' ability to repay their debts. Unlike most governments, corporations are not guaranteed to remain solvent to honour their debts. So, these bonds pay a higher coupon than government bonds because they are considered a higher credit risk than governments. Therefore, what matters for these bonds are corporate earnings, which affect the price of these bonds because they are an indicator of the issuer's ability to repay the debt on maturity.

Therefore, a rate hike that is perceived to be reccessionary will cause corporate bond yields to rise and bond prices to fall because a recession would jeopardize the earnings potential for corporations. This effect is in direct contrast to government bonds whose prices generally rise when recession looms.

So what about some practical applications? Start by looking at inflation. When inflation is expected to rise, usually a consequence of strong economic growth, the government will be expected to raise interest rates. Inflation has a wealth-eroding effect, which means that it reduces the future value of your money. Therefore, if investors believe that the government's rate hike was insufficient to combat inflation, they will demand a higher yield from the bond in order to be enticed into buying it. Thus, the price of the bond drops. On the other hand, when the government raises rates too much, or when a recession is looming, longer-term bonds stand to benefit the most because investors will expect a deflationary period.

When investing in a bond fund, you must first find out if the fund invests in short-term, long-term, corporate bonds, or a mix of these. Corporate bonds need a strong economy without inflationary fears and can suffer severely during a recession. Short-term bonds are affected little by rate hikes because they mature so quickly. Long-term bonds are the most volatile of the lot and are most sensitive to inflation.

Sadly, the large gains that were made in bond funds in recent years due to falling inflation and the government's budget balancing act are diminishing. There may be some life left in bonds if inflation falls further due to recession, but investors holding a long-term bond fund are not likely to make more than 10% a year and even that would be impressive. Investors should consider looking to bond funds that hold corporate issues- a market that is becoming more liquid, unlike the one for government bonds.

If you missed Part One of The Interest Rate Game, you can read it here.

Levi Folk and Richard Webb are editors of the Fund Counsel newsletter, a monthly publication for independent mutual fund investors. They can be reached on the Web at www.fundcounsel.com or by E-mail at editors@fundcounsel.com.

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