Investing in a Low Interest

via Financial Post | July 23, 2011

For older investors holding mostly fixed income, this protracted era of ultra-low interest rates has been a frustrating low-yielding experience. Based on what economists said this week, they may not be getting relief for a few years yet.

When bonds or GICs mature, investors must choose between accepting much less yield than the bond that’s just come due, or pushing out maturities longer than may seem prudent for those expecting an imminent jump in rates. This also makes it a frustrating time to annuitize.

For some years, financial advisors have suggested staying “short” – keeping bond maturities under five years – but what once seemed just a temporary stop-gap measure now appears to be a chronic source of under performance.

But attempts to stay short in anticipation of rising rates can just end up costing investors money, as ScotiaMcLeod advisor Robert Cable argues on the facing page.

On Wednesday, the Bank of Canada suggested rates may start rising in the second half, but only “gradually.” BMO Capital Markets chief economist Douglas Porter said the bank’s stance “certainly does not rule out rate hikes, but it does affirm that rates are highly unlikely to approach so-called neutral (3% to 4%) perhaps until well into 2013, and potentially even later.”

He says the bank’s “neutral” overnight rate averaged 4.15% in the 15 years leading up to 2007, but based on demographics and slower economic growth, suggested the “new neutral” is closer to 3.5%. “The BoC sees no need to get there soon.”

“We’ve been saying for a while get used to 4% bonds,” says Warren Baldwin, regional vice-president for Toronto-based T. E. Wealth. “We don’t see rates being earthshakingly higher than that for the foreseeable future.”

His firm uses pooled bond funds or bond ETFs using a mix of government and corporate issues of various maturities. Those managers tend to be going shorter on maturities but investors shouldn’t be shooting for yield on the bond part of their portfolios: What risks they take should be on the equity side, Baldwin says.

There is no easy answer beyond maintaining a properly diversified portfolio, says Clay Gillespie, managing director of Vancouver-based Rogers Group Financial. He has used preferred shares lately to boost yields on the conservative side of client portfolios, while shortening durations on the bond portion.

The canary in the coal mine is inflation, which is starting to heat up. According to Statistics Canada, the headline inflation rate hit an eightyear high of 3.7% in May, driven by almost a 30% spike in gas prices and 4.2% jump in food prices, but then slowed to 3.1% in June as energy prices slipped back down.

However, governments prefer to understate inflation by using the less ominous “core” rate (famous for applying to those rare people who “don’t eat or heat”), which was 1.7% in April and May but dipped to 1.3% in June. The Bank of Canada expects core inflation to subside and total CPI inflation to return to the normal 2% target by mid-2012.

If the inflation genie escapes the bottle, the rise in economic growth and commodity prices will force the hand of the U.S. Federal Reserve and other central banks. They will hike interest rates, perhaps sooner and faster than investors anticipate.

Most consumers feel true day-byday inflation is much higher. The record price of gold, which passed US$1,600 this week, suggests a more serious rate of inflation is around the corner. No mystery why: On the one hand, the world’s central banks try to understate the true extent of inflation but on the other it’s they that create more inflation by running the printing presses. Call it quantitative easing or any other euphemism you choose but it’s clear inflation is coming to a theatre near you.

According to Wainwright Economics, gold and other precious metals can hedge against inflation in both stock and bond portfolios. Other inflation hedges include inflation-linked real-return bonds, commodities, real estate or REITs, and arguably stocks.

Michael Nairne, president of Toronto-based Tacita Capital, says gold is correlated to high and rising inflation but has an even bigger correlation to negative interest rates and an inverse correlation with the U.S. dollar. Tacita has published a white paper on precious metals ETFs but Nairne sees no need for more than a 3% to 5% position in gold, ideally in the mining stocks. “My belief is we will start to see the market worrying seriously about inflation by the middle of next year.”

But that doesn’t mean rates won’t rise for another three or four more years. “I think they’ll move up in advance of that,” Nairne says. Canada would have raised rates already had it not been for the dire situation elsewhere, he says. Once they start rising, “higher interest rates here could be very painful.”

The contrary view is the tug of war between inflation and deflation will tilt in favour of deflation, which is where longer-term bonds will thrive, Nairne says. In the current environment, some wealthy clients are using private or public mortgage investment corporations (MICs) that provide high yields (albeit with more credit risk) in one-or two-year maturities. Some are also using short-term split preferred shares.

If you’re a debtor, I’d be locking in mortgage rates for at least five-year terms right now. The 2% you save by staying short in variable mortgages could soon seem like a false economy once rates start rising, and repeatedly.

If you’re a creditor/investor with a reasonable time horizon and risk tolerance, risk/reward tradeoffs appear to favour quality large-cap, dividend-paying stocks over bonds, as reviewed in my column earlier this week. Lisa Myers, manager of Templeton Growth Fund, told unitholders Thursday that in Europe and the United States, dividend yields are greater than bond yields in defensive sectors like health care, consumer staples, telecommunications and utilities.

A similar strategy can be used here in Canada. Leslie Lundquist, co-lead manager of Bissett Canadian High Dividend Fund said the fund – formerly focused on high-yielding income trusts – now yields 6.5%, or more than double the 3% bonds are paying. Combined with a bond fund, investors can “get income in a conservative way,” she said.

While that 6.5% yield might be affected if rates rise, “historically we find companies can skate through modest increases,” she said.


The problem with investing is predictions, especially about the future, are very difficult. For those who DO think they can predict, for example, where interest rates are headed, here are some logical investment ideas. Just remember though: Your view on interest rates is really just a guess.


Keep bond maturities short (under five years) or “park” in cash or cash equivalents, hoping to reinvest if and when rates do rise. Debtors would lock mortgages at fixed rates for terms of five years or more. Take more risks on the equity side but conservatively, substituting some of your longer-term bonds or those now coming due with high-yielding utility, telecom or pharmaceutical stocks or funds or ETFs with similar exposure. For taxable portfolios, consider preferred shares. If you think inflation will rise in concert with rising rates, or vice versa, consider realreturn bonds and some exposure to commodities or commodity stocks, precious metals and real estate or REITs. Aggressive investors could even buy inverse bond funds that rise in value as interest rates spike up.


Maintain bond or GIC ladders over five years; use bond mutual funds or ETFs broadly diversified to include corporate and government issues of various maturities. Global bond funds may find more yield outside Canada but the tradeoff will be currency risk. The more you believe rates will fall, the longer you would extend bond maturities. Homeowners would stay “short” in variable-rate mortgages. Even if inflation doesn’t arrive, top-quality, dividend-paying stocks that consistently grow their dividends over time will protect purchasing power, especially if dividends are reinvested. J.C.

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