While experts agree that bonds are an essential part of every portfolio, rising interest rates combined with the staggering array of new and old fixed-income products available makes choosing and managing them a potentially overwhelming task. What happens when interest rates go up? How do you interpret bond ratings? What are the key factors to consider?
Here are some strategies for creating and maintaining a fixed income portfolio that’s right for your goals and time horizon — balancing the desire for higher yield with the need for safety while preparing for interest rates to eventually rise.
Preparing for rising rates
When interest rates go up, the price of bonds already issued typically goes down — compensating for the higher rate available on new-issue bonds. What to do? For bonds you currently own, hang onto them because the interest they pay isn’t affected by a rate increase.
Only the bond’s price changes, which then affects its value if you sell it. For new bond purchases, consider laddering — a simple, classic strategy that’s designed to take advantage of fluctuating or rising interest rates.
Laddering entails buying bonds (or Treasury bills or Guaranteed Investment Certificates) of different maturity dates. As they mature, you’ll be reinvesting at varying times and rates. Laddering ensures you spread out your purchases over time to capture opportunity.
In a rising rate environment, you should also know about “floating-rate bonds”: their payouts rise when interest rates rise, unlike regular bonds, whose interest rates are fixed. Floating-rate bonds follow the interest rate on three-month Treasury bills.
If the T-bill’s rate goes up, you’ll receive more interest. By the same token, if rates drop, so does the payout.
Balancing yield and risk
Fixed-income investments that provide higher yield typically means higher risk. One important tool for assessing the risk of fixed income is the credit rating, which is a measure of credit-worthiness and likelihood of default.
Ratings are simply opinions, not guarantees. In Canada, the big rating agencies are the Dominion Bond Rating Service (DBRS) and Standard & Poor’s (S&P).
Ratings for long-term fixed income range from the highest quality credit to default. They include:
• AAA or AA – Bonds rated “triple A” are of the highest quality; “double A” means superior credit quality
• A –”Single A” bonds are of satisfactory credit quality, but are more susceptible to changes in circumstances and economic conditions
• BBB + or – (or high or low) – A bond is considered “investment grade” if its credit rating is BBB- and higher by S&P, or BBB (low) and higher by DBRS
• BB or lower – Issues rated BB or lower are referred to as “high yield” or “speculative”
The following are some higher-yield choices, with varying levels of risk:
• Provincial and municipal bonds tend to provide higher yields than those from the Government of Canada and are considered safe issuers because they can raise money through taxation.
• Corporate bonds provide higher yields than government bonds (instead of lending your money to the government, you’re lending your money to a company with corporate bonds). To mitigate risk, consider investing through a mutual fund so you can spread your risk across many companies.
• Emerging market bond funds are mutual funds that invest in fixed income issued by governments and corporations of emerging economies. Yields can be significantly higher than those of developed economies, but you do accept more risk.
Key factors to consider:
The first step to take in building the fixed-income portion of your portfolio is to filterer out investments that aren’t suitable for you. Factor in your goals, income needs, and time horizon.
Then consider the quality and safety of an investment, its credit rating, and whether that rating makes it appropriate for your portfolio. And, depending on your goals and time horizon, look at liquidity — whether or not you can sell quickly in an emergency to and not lose too much money.
Together, we can weigh the risks and rewards of fixed-income investments, taking into consideration your goals, investment time horizon, and risk profile, as well as the current market and interest rate environment, to make the most of your fixed income portfolio. Please feel free to email me at Heather_Holden@ScotiaMcLeod.com or call me at 604-661-1523 for an appointment.
Heather Holden, PhD, CIM
Wealth Advisor, ScotiaMcLeod