Retiree do's and don'ts in a rising-rate environment

Rising rates aren't an unmitigated evil for your finances and portfolio, but some perspective is in order.

Christine Benz 20 July, 2018 | 5:00PM

The Bank of Canada raised interest rates last Wednesday, bringing its overnight rate up to 1.5%, and indicated that it expects rates to continue to move up. This marks the fourth increase in 12 months for the key policy rate, which is now at its highest level since 2008. In a statement, the Bank noted the strength of the global economy, including "stronger than expected" growth in the United States, while highlighting its belief that inflation in Canada was under control at around the 2% level.

Many market participants, especially retirees with fixed-income-heavy investment mixes, are reasonably concerned about what a period of rising interest rates could mean for their portfolios and for the rest of their financial lives. Will the bond market, which has experienced declining yields but enormous price appreciation over the past three decades, reverse course? Will the losses that bond investors have experienced over the past year persist, making bonds a lost cause (or worse) in the decade(s) ahead?

I think a more nuanced take is in order. Yes, higher yields have the potential to depress bond prices in the near term. Over time, however, they're apt to have a benefit for retirees, because income contributes the largest share of the return that bond investors earn. We've already started to see higher yields accruing to investors in search of income: Even as many bond-fund types have seen flat returns so far in 2018, the yield on the FTSE TMX Canada Universe Bond Index is now around 2.7%, and cash yields have also been climbing steadily.

In addition, I think it's a mistake to assume that interest rates will run inexorably upward, much as they did in the 1970s amid runaway inflation. While the economy appears to be on solid footing and inflation is trending higher, inflation is nowhere near levels that could be described as "runaway." Moreover, the current economic expansion is now nine years old, one of the longest in Canadian history. Even as higher rates are a worry, it's also possible that economic growth could begin to wane. Such a scenario would tend to weigh on stocks, while rate-sensitive bonds could prosper.

As you consider your financial and portfolio strategies amid expected future interest-rate hikes, here are some dos and don'ts to help your portfolio and the rest of your finances, weather the storms.

Do shop around for the highest cash yields

Not so long ago, 2.2% was the approximate yield on the FTSE TMX Canada Universe Bond Index, while cash yields were barely in the black. Today, it's possible to pick up a 2.5% yield on a 12-month GIC! Meanwhile, yields on money market mutual funds are finally above 1%, and it's easy to find an online savings account that's yielding 1.5%. That means it's time to re-shop your cash holdings to ensure that you're getting the best yield you can. As you do so, be sure to factor in your need for liquidity and CDIC protections. Yields will tend to be highest on GICs, and GICs offer CDIC protection (up to the limits); the downside is that you won't have daily access to your funds, so GICs are a poor choice for ongoing expenses. Money market mutual fund yields are inching up, but they're still well below those on online savings accounts; these funds offer daily liquidity but aren't CDIC-insured. Online savings accounts are CDIC-insured up to the limits and offer daily liquidity; in many ways, they offer the best of both worlds.

Don't let more money languish on your brokerage cash account than you really need

As you're attempting to wring a higher yield out of your cash holdings, don't ignore the cash you have sitting alongside your long-term portfolio holdings in your brokerage account. Such cash accounts, often called "sweep" accounts, offer ready access to purchase long-term securities, but they typically offer yields that are well below competing types of cash accounts. In most cases, brokerage sweep accounts are paying less -- typically well less -- than 0.50% today. You can usually find higher yielding savings accounts at your brokerage firm or bank.

Do stress-test the impact of rising rates

Rising interest rates have a depressive effect on bond prices; when higher-yielding new bonds come available, that puts downward pressure on older bonds with lower yields attached to them. Rather than assuming Armageddon is nigh for your bond because of higher rates, it's useful to conduct a quick and dirty "stress test." For high-quality bond holdings, you could expect them to lose the amount of their durations, less their yields, in a one-year period in which interest rates trended up by one percentage point. Take  iShares Core Canadian Universe Bond ETF (XBB), for example. With a duration of seven years and a 2.9% 12-month yield, investors could expect a roughly 4% loss if rates increased by one percentage point over the next year.

Don't assume individual bonds are a panacea

Rising rates are only a problem for investors in bond funds, right? Well, sort of. If you hold an individual bond to maturity and the issuer makes good on its interest payments, you won't lose money, even if interest rates shoot up over your holding period. But investing in individual bonds carries drawbacks of its own. It can be difficult for smaller investors to adequately diversify across bond sectors and issuers with individual bonds. Those individual bonds may be tough to research; as a small investor, high trading costs could eat into your returns. Bond mutual funds, by contrast, offer professional management and diversification. Moreover, an investor in individual bonds effectively locks in his or her yield, whereas the bond-fund managers can take advantage of higher-yielding bonds as they become available. This article discusses in greater detail the pros and cons of buying individual bonds.

Do rethink your debt

More and more people are carrying debt into retirement--mortgages and even student loans. And while rising interest rates may be a boon to savers, they're bad news for borrowers. The average posted rate on 5-year fixed mortgage recently stood at 5.34%, their highest level since 2013. For new borrowers, those higher rates make it hard to beat debt paydown as the highest guaranteed return on investment that retirees can earn today. Even investors who have older mortgages with very low rates of less than 3.5% may want to balance prepaying their mortgages with investing in the market. While safe yields have gone higher, you still can't find a 3.5% guaranteed return anywhere.

Don't ignore inflation

Inflation, as measured by the Consumer Price Index, rose at 2.2% in May after going as low as 1% a year ago. Of course, there have been numerous head fakes on the inflation front over the past decade, but inflation in Canada has remained stubbornly low overall and hasn't topped 2.5% in more than six years. For investors with fixed-rate investments, however, I'd put minding inflation in the category of "better safe than sorry," because inflation can eat away at the purchasing power of the income they pocket. I like the idea of including inflation-protected bonds in a fixed-income portfolio for retirees. And while stocks are by no means an inflation "hedge," they do offer investors the best long-run shot at outpacing inflation.

Do stay mindful of equity rate sensitivity

Bonds usually get all the attention in periods of rising interest rates. But don't ignore the potential rate sensitivity of your equity holdings. Investors often use income-producing equities like REITs and utilities as fixed-income surrogates; when yields trend up, the prices of these equities often decline right along with bond prices. That's not to say you shouldn't own them; in fact, Morningstar's analysts think REITs and consumer staples, which offer higher yields than the broad market, look pretty attractive from a bottom-up standpoint today. But if you're an income-focused investor, be careful to avoid building a portfolio whose holdings all move in unison in response to interest-rate changes.

Don't lose sight of the big picture

Rising interest rates do have the potential to lead to bond losses in the years ahead, and it's wise to brace for that possibility. But as T. Rowe Price retirement-fund manager Wyatt Lee noted on a panel discussion at the Morningstar Investment Conference, "A bad year for bonds is the same as a bad day for stocks." In other words, while you'd rather not have losses in the safe part of your portfolio you've earmarked for bonds, tumult in the bond market is going to be a lot less painful in absolute terms than will a sizable downturn in the equity market. Rather than getting hung up on micromanaging risks in your bond portfolio, a better use of your time is to revisit your portfolio's core asset-class exposures. If you've been hands-off with your portfolio and have let your equity exposure drift up, it's a good bet that you're courting more risk than you intended to.

About Author

Christine Benz

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.