In our previous post, we talked about the relationship between bond prices and market interest rates. The Coles Notes version: when interest rates rise, bond prices fall and vice versa.
For Canadians who own publicly traded government and corporate bonds (as opposed to savings bonds), the effect of rising rates on bond values is not just theoretical: in recent months, interest rates on benchmark 5 and 10-year government bonds have risen. This has hurt the value of bonds and bond funds owned by investors.
Granted, bonds have done very well in recent years, so the recent drop should be put into perspective. Nonetheless, some investors may not feel comfortable buying fixed income products that will suffer if rates continue to rise. What’s someone in this boat to do?
One option is to buy GICs instead. Unlike bonds, the price of a GIC is not affected by changes in interest rates*. There is, of course, an opportunity cost if you buy a GIC, especially a long-term one, and rates rise, but because GICs aren’t traded, there is no risk to your principal.
Over at The Globe and Mail, Rob Carrick (whose post inspired this one) suggests two GIC strategies for investors in a rising interest rate environment.
First, individuals can employ a GIC ladder. This way, every year a GIC will be maturing and the proceeds can be used to take advantage of (possibly) higher rates. Alternatively, a different way of achieving this result is to maintain a large enough weighting in cash. Then if interest rates rise, you can buy a GIC at a now-higher yield as a way of profiting.
Carrick adds a disclaimer we’d concur with: if the economy meaningfully slows down, interest rates will likely fall and that means higher bond prices. A GIC investor won’t suffer (in fact, they will have locked in comparatively higher rates), but they probably won’t gain as much as bond investors will. The latter will see their bonds and bond funds rise in value (recall the inverse relationship between bond prices and interest rates as explained in our previous post).
All in all, it’s important for fixed income investors to understand both the risks and rewards when they own corporate and government bonds (directly or via bond funds). Bonds aren’t as volatile as equities, but changes in market interest rates will have an impact on the value of these fixed income investments. They will rise if interest rates fall, but fall if rates climb. Give some thought as to whether the latter possibility is a risk you’re ok taking.
*We’re only talking about traditional GICs here. Interest-linked GICs will obviously be affected by interest rate changes. And to a certain extent, equity-linked GICs may be indirectly affected as well.
Flickr: KMR Photography