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What do rising interest rates mean for your portfolio? - January 2018

By ATB Financial 8 March 2019 4 min read

Thanks to a strengthening Canadian economy, the Bank of Canada (“the Bank”) increased the target overnight interest rate by a quarter percent to 1.25 percent in January 2018. On a path to normalization, this rate increase follows two other quarter percent hikes last year, where the Bank raised rates from .50 per cent to 1.00 per cent. The Central Bank will most likely continue to hike rates, with 1 to 2 more expected this year. Although the economic backdrop is currently upbeat, the Bank will proceed with caution, citing potential concerns over the NAFTA renegotiations and high consumer debt levels.

 

A little more about the target rate

The target rate is the Bank’s main tool to implement monetary policy​. This rate directly affects one-day borrowing and lending between Canada’s major financial institutions, and ultimately influences interest rates on mortgage loans, automobile loans, home equity lines of credit and other loans. Expectations of this week’s rate increase led to an appreciation of the Canadian dollar against the US dollar, and also contributed to the recent sharp increase in longer-maturity Canadian bond yields.

The impact of monetary policy changes on the economy plays out over time. Central bankers widely believe that there are long-term risks if interest rates remain extremely low for too long; however, there’s also a risk that rapid rate increases will slow an economy too quickly and tip it into recession. We believe the Bank will continue to raise its target rate but will do so cautiously and gradually, to avoid the latter scenario.

Canadian Target Overnight Interest Rate (%)


How rate increases affect fixed income portfolios

The target rate strongly influences short-term interest rates and the prices of shorter-term bonds, but has less direct impact on bonds with longer-term maturities:

  • The longer a bond’s maturity, the more sensitive it is to a given interest rate change.
  • Interest rate changes are typically smaller for longer-term than for shorter-term bonds, but this doesn’t entirely offset the longer-term bonds’ higher sensitivity—their price movements tend to be of greater magnitude than those of shorter-term bonds.
  • Bond yields and bond prices have an inverse relationship, meaning bond prices increase when bond yields decrease, and vice versa.
  • With interest rates rising, bond prices will fall.

 

ATB Investment Management mitigates the risk of rising interest rates

In response to the very low interest rates following the 2008-09 global financial crisis and recession, bond holdings in the Compass portfolios were gradually moved largely away from federal and provincial government bonds into corporate and commercial borrowings:

  • The Canso Corporate Value bond and the CMLS commercial mortgage-backed securities mandates both include primarily shorter-term borrowings. This means they aren’t overly sensitive to interest rate changes.
  • The Canso Investment Grade Corporate bond mandate contains some longer-term bonds. This makes is more sensitive to rate changes than the other two. That said, it’s still less sensitive than the broad Canadian bond market to interest rate changes.

As illustrated by the first half of 2017, Compass’ fixed income components move in the same direction as the broad bond market but by much smaller amounts.

Compass bond componets vs. Universe bond index (Growth of $100 in 2017)


Regardless of where you invest, have your advisor explain their investment philosophy and and how they are working to guard your portfolio from a rising interest rate environment.

This report has been prepared by ATB Investment Management Inc. ("ATBIM”) which manages the Compass Portfolio Series and ATBIS Pools. ATBIM and ATB Securities Inc. ("ATBSI") are wholly owned subsidiaries of ATB Financial and operate under the trade name ATB Investor Services. ATBIM and ATBSI are licensed users of the registered trademark for ATB Investor Services.

The performance data provided assumes re-investment of distributions only and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any security holder that may reduce returns. Unit values of mutual funds will fluctuate and past performance may not be repeated. Mutual Funds are not insured by the Canada Deposit Insurance Corporation, nor guaranteed by ATB Securities Inc., ATB Investment Management Inc., ATB Financial, the province of Alberta, any other government or any government agency. Commissions, trailing commissions, management fees, and expenses may all be associated with mutual fund investments. Read the prospectus provided before investing. The Compass Portfolio Series and ATBIS Pools includes investments in other mutual funds. Information on these mutual funds, including the prospectus, is available on the internet at www.sedar.com.

Opinions, estimates, and projections contained herein are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. ATB Financial, ATBIM and ATBSI do not accept any liability whatsoever for any losses arising from the use of this report or its contents.

This report is not, and should not be construed as, an offer to sell or a solicitation of an offer to buy any investment. This report may not be reproduced in whole or in part; referred to in any manner whatsoever; nor may the information, opinions, and conclusions contained herein be referred to without the prior written consent of ATBIM.

Bank of Canada image courtesy of Wikipedia.​​​

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