Tuesday, May 31, 2011

Fixed income investments and the trouble with interest rates

Fixed income investments – savings accounts, bonds, mortgages, T-bills, Guaranteed Income Certificates (GICs) and the like -- are typically viewed as ‘safe haven’ investments by many investors. And for the past 30 years or so, bonds especially have enjoyed an almost uninterrupted period of steady, if not spectacular, growth. But with interest rates sitting at historical lows, there is likely little opportunity left for further appreciation in the price of bonds. So, what can you expect from an investment in bonds? That depends on whether interest rates begin to go up or remain flat. Let’s take a closer look.

If interest rates rise, expect increased volatility in bond prices. As interest rates go up, new bonds are issued at the higher rate, making them more attractive than existing bonds. For example, if you buy a bond that yields (pays) 5 per cent interest and interest rates rise to 6 per cent, your bond will be worth less because new investors are getting a better yield.

Keep in mind that the impact of interest rate changes on existing bonds depends on the type of bond you invest in. For example, if interest rates increase by just 0.25 per cent, the value of a long-term bond could drop by more than 1 per cent, while a short-term bond would typically see a much smaller drop in value.

If interest rates experience a steady rise, income from bond mutual funds will eventually climb as fund managers find greater value by adding bonds with higher yields, which will help to slowly rebuild income levels and provide better volatility protection.

Inflation expectations can also produce bond market volatility. Inflation usually leads to higher interest rates and even the expectation of an inflationary period can drive down bond prices well in advance of an actual interest rate change.

If interest rates remain flat or fall, cash flow from bond interest flat lines or declines making it more difficult to achieve your financial goals and effectively eliminating protection against price increases.

Faced with low interest rates, some investors choose to move to higher yielding corporate bonds in hopes of increasing their income. Corporate bonds typically perform well in a stable economy but during economic crises there is more risk that high yield bond issuers will become insolvent. That creates volatility in high yield bond prices and results in a flight to quality investments and risk free assets like T-Bills or perhaps Canadian government bonds, further reducing the value of lower credit quality assets such as high yield bonds.

Any way you look at it, volatility and low yields are expected continue in the bond market for some time. Even so, investors should still view fixed income investments as an important asset class to manage market risk. The cost for this relative stability is it’s lower long-term growth potential, which makes portfolio diversification among all asset classes – cash, stocks, equity mutual funds, bonds and other fixed-income investments – the key to successfully reaching your long-term financial goals. Talk to your professional advisor about how to keep your financial life safe and balanced come what may.

No comments:

Post a Comment