Prep your portfolio for higher rates

With the U.S. Federal Reserve starting to raise rates, the Bank of Canada is now openly discussing the possibility of doing the same here. Senior deputy governor Carolyn Wilkins recently said that given continued and broadening growth, the central bank would assess whether the “considerable monetary policy stimulus presently in place is still required.”

Translated from central bank-speak: unless the economy hits a speed bump, higher rates are on the horizon.

All of this gives bond ETF investors a lot to think about. In a strategy piece published in mid-June, National Bank ETF analyst Daniel Straus and his colleagues laid out two possible paths for the bond market and offered ways investors can act accordingly.

The consensus fixed income scenario

The first scenario envisions an environment where rates rise slowly. It’s predicated on the notion that the Bank of Canada enacts a series of rate hikes over time and longer-dated yields rise as a result. National Bank’s economists, for example, see the central bank raising rates twice by the first quarter of 2018. In turn, they see the Canada 10-year bond yield, which currently sits at 1.50%, rising to 2.43%.

Sign up for our free investing newsletter »

Investors who buy into the consensus view should consider shortening the duration of their bond ETF portfolio, advises Straus in his research note. In other words, steer towards shorter-dated bonds versus the longer-term variety, as longer-term bond prices are more sensitive to changes in interest rates. If you’re unsure which ETFs to focus on here’s a look at the short-term  bond ETFs in Canada:

The alternative fixed income scenario

While the consensus view sees rates rising, there’s no guarantee that a Bank of Canada rate hike campaign—which is still not a certainty—will actually result in higher long-term rates. This leads to the second scenario identified by Straus’ and his team: “Contra-indicative yield curve flattening and/or inversion.”

His team points to the last time the Bank of Canada raised rates, in 2010. Despite three hikes, from 0.25-1.00%, the Canada 10-year actually fell from 3.60-3.10%. In this case, Canadian bond markets were more focused on the U.S. than the Bank of Canada. Canadian rates are often highly correlated with U.S. rates, explains Straus. “The U.S. 10-year yield slid in 2010 due to market jitters caused by the “flash crash” in stocks and the Greek debt crisis. Canada’s 10-year yield also fell because of economic data that came in below market expectations.”

Hence, long-term bond ETFs actually outperformed their shorter-term counterparts. This scenario could play out again if, to quote National Bank, “the Bank of Canada raises rates sooner than warranted by Canadian economic fundamentals or international developments.”

If you don’t think the Bank of Canada has room to hike rates without derailing the economy, you’ll probably subscribe to Straus’ second scenario. In this case, his team suggests investors maintain the duration of their bond ETF holdings.

Such a strategy, he says, is more appropriate for more aggressive investors because “they tend to have lower allocations to fixed income overall.” If you are bearish on equities then a rally in long bonds (i.e. a decline in yields) would likely act as a hedge for declines in an aggressive investor’s equities, says Strauss.

National Bank observes that, “Canadian bond ETF investors have long been positioned for a rate hike scenario.” In fact, they note that thus far in 2017, long-term bond ETFs have received the lowest inflows among bond ETFs ($452 million vs. $1.1 billion for short term ETFs). Hence, as Straus tells MoneySense, “One of the contrarian trades is to move into long bonds.”

The Risk of Over-Reacting

Greg Walker, Head of Institutional ETF Business at Vanguard Canada, cautions investors against over-reacting to news affecting the bond market. “Timing rate news profitably is not as easy as it seems,” he says. Further, Walker argues that “once you become too tactical, the costs in your portfolio start climbing,” citing transaction costs (i.e. trading fees) and capital gains. What’s most important for an investor, he says, is having that long-term strategic asset allocation nailed down.

For most investors, that probably means having a mix of short to longer-term fixed income exposure in their portfolios, without going too heavy in either direction.