With global interest rates beginning to rise due to central
bank unwinding their balance sheet and low interest rates policies, this is
indeed positive news for retirees, prospective retirees or investors seeking a safe
haven from the volatility in investing in equities. Mind you, I think we are
still in the early stages of a rising interest rate environment. Based on
historical evidence, equities will continue to do well in the initial stages of
rising interest rates (due to indication of economic growth).
As you know, the stock price is based on the present value of future cash flows on a company discounted using current interest rate. As rates increased, assuming everything else remaining constant (ceteris paribus), the price of the stock decreases.
Bank of Canada has increased rates twice already this year.
The Government of Canada 10-year bond has spiked to 2.1%, which is the highest
since late 2014. As seen in the Canada 10-year
bond chart below, the highest rate in the past 5-years was 2.8% in December
2013. My prediction is that there will
be at least 3 or more rate hikes by the end of 2018. The U.S. is on a similar trajectory. The E.U.and
the United Kingdom have indicated an end
to the easy monetary policy, but have yet to officially raise interest rates.
From a portfolio allocation standpoint, my suggestion would
be to start increasing exposure to fixed income (or bonds), and stay in the mid-end
of maturity (no more than 10 years). Duration is the key measure of a bond’s
sensitivity to changes in interest rates.
For example, if the duration is 5, this means that the price of a bond
will increase by 5% if yield decreases by 1%. Note that price of bond is inversely related
to yield. Conversely, the price of a
bond will decrease by 5% if yield increases by 1 percent.
A sample corporate bond from Brookfield Asset Management
below , which as an investment grade rating of A1 and maturing approximately 10
years from today yields 3.72%, or 150 basis points higher than a 10-year Government
of Canada bond.
If you stagger your bond maturities and purchase an equal amount
of 3-year bond from Hydro One that yields 1.92% as you did with Brookfield
10-year bond above, your weighted average yield on your bond portfolio would be
2.82% . rough estimate of Duration would be approximately 6 years. Since rates are expected to continue to rise, you
would do well to stay at that duration level.
One may question why invest in bonds that yield less than 3%
on average when rates continue to go up.
One can easily buy dividend
paying stocks that yields more than 3%. The biggest reason for purchasing bond is the peace
of mind that bonds provide during uncertain times. Case in point, during the
2008 market crisis, a 40% allocation to government bonds specifically would
have cushioned your portfolio losses by more than half.
Another reason is that bonds typically pay more than the
interest provided by banks.
Lastly, bondholders typically have priority over
stockholders if a company goes bankrupt.
Hence, the dividend or more importantly, the principal amount invested
in the common stock may not be totally safe.
My ideal portfolio will provide a return of 6% consisting of 60% Equity, assuming return
of 8% and 40% Fixed Income assuming Return of 3%. Returns above are assumed to be net of
inflation and investment fees. I know
people are going to balk at that return and will probably say that investing in
Facebook or Amazon alone can quadruple the 6% above. I challenge anyone who can do this
consistently, though. More important than the 6% return is that the portfolio above
can reduce the volatility of your portfolio by reducing the expected standard
deviation of returns. In other words, you have a better change of achieving a 6% return on average than hitting a home run consistently.
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