The Bank of Canada and the federal government have spent the past month trying to get the message across to as many investors as possible to be mindful of higher interest rates ahead. Canadians need to make sure their portfolios are prepared for future rate increases that may come as early as June 2010. If interest rates do rise at some point this year, how will this affect investors that own fixed rate securities such as bonds or bond funds in their portfolios?
Bonds are investments that are unfortunately misunderstood by a lot of investors. A bond is an agreement between a borrower and a lender whereby the lender agrees to loan money to a corporation or government (the borrower) and for doing so receives interest for as long as the loan is outstanding. At the end of the term of the loan, the borrower pays back the amount borrowed and the transaction is complete.
All bonds have a price attached to them because they can be purchased on a daily basis. When bonds are first issued, the price is $100. The price of a bond can move higher or lower, depending on the prevailing interest rates at the time. If interest rates move higher, the price of bonds in general falls. If interest rates drop, the price of a bond will rise. Thus, it is possible for an investor to buy a bond trading for less than $100. This would mean that the bond is trading at a discount and therefore the rate of return would be higher than when the bond was first issued.
For example, if you can purchase a bond paying five per cent at a price of $99 versus the full $100 cost, you would be getting the same amount of return, yet you would only be paying $99 for every $100 of the bond you are receiving. Thus, in our example, the bond holder would make five per cent for the life of the bond and a small capital gain of one dollar per bond purchased.
Currently in Canada, interest rates are at all-time lows. Therefore, most bonds are selling at prices well above $100. However, if interest rates begin to rise over the coming year, bond prices will begin to fall and become less expensive to buy for investors. For new purchases, this would increase an investor’s rate of return as the bond would cost less to purchase. For bonds that are currently held in portfolios, the price of these bonds would gradually fall as interest rates rise, effectively lowering the value of the investment and the whole portfolio. If an investor were to own bond mutual funds (a mutual fund that owns a basket of different bonds), it is possible that the price of the bond fund could fall as well.
If an investor owns an individual bond to maturity, regardless of what interest rates do, they will get the matured amount back (face value). Thus, investors should not be worried about rising interest rates if they are going to hold their bond investment to maturity. For those investors that hold bond mutual funds or even bond ETF’s, there is no final maturity date for these products and thus these types of investments can fluctuate when interest rates change. Investors need to be mindful of this.
In my opinion, interest rates will rise this year in both the U.S. and Canada. I do not believe they will rise significantly enough this year to effect fixed income investments too much. However, investors need to be mindful of the changes that will occur due to higher interest rates, especially if they own fixed income securities in managed products like mutual funds.
If you have any questions regarding the above article or are looking for an Investment Advisor to help you with your portfolio, please send me an email at email@example.com. I will be glad to speak with you!
Allan Small is an Investment Advisor with Dundee Securities Corporation, a DundeeWealth Inc. Company. This is not an official publication of Dundee Securities and the author is not a Dundee Securities analyst. The views expressed are those of the author alone, and are not necessarily those of Dundee Securities or Metro Canada.