Investors getting burned by falling rates

Like many investors, Norman Levine was sure that interest rates were going to rise. He was so sure that he bought a number of rate-reset preferred shares, which are shares that reset their dividend every five years. If rates rise, those payouts climb. If not, they fall. Unfortunately, for Levine – and the many other investors who adjusted their portfolios thinking that rates were on a steady climb higher – long-term interest rates have fallen, while short-term rates may not be moving much this year either. “Our preferreds got clobbered,” says Levine, a managing director at Toronto’s Portfolio Management Corporation. 

Over the last year or so, portfolio managers, economists and journalists like me, have been talking about how interest rates are going to rise and the destruction that would cause in rate sensitive sectors, such as utilities, real estate investment trusts and telecoms. While we were right at first – between January 2 and October 1, 2018, the 10-year U.S. Treasury yield climbed by 33%, while the S&P/TSX Capped Utilities Index fell by 11.6% in 2018 – what no one predicted was that long-term rates would start dropping and overnight rates rises would stall.

Since October 1, the 10-year U.S. Treasury yield has fallen by 25%, while, year-to-date, the S&P/TSX Capped Utilities Index is up 14.75%. The S&P/TSX Capped REIT Index, which was basically flat in 2018, is also up 14.39% and the S&P/TSX Composite Index Communication Services Sector Index, which tracks telecom companies, is up 8.79% since January. It’s a similar story stateside.

Now, with some people saying that Canada and America’s overnight rates, both of which were increased multiple times in 2018 and were expected to rise two or three times more in 2019, could see cuts, you’re probably wondering why you dumped all those interest rate sensitive stocks over the last few months. At least you’re not alone. “I can’t point to a single strategist or economist who said last summer that rates were going to collapse,” says Levine.

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This is a prime example of how impossible it is to predict the markets. As much as we (and that includes me) like to talk about where stocks may be headed and what sectors are your best bets, until someone creates some foolproof predictive analytics tool, we can’t know where the economy is headed or where rates will go. To Levine, who has learned the hard way, predicting interest rate movements is no different than predicting currency direction. “No one in the history of mankind has consistently predicted currency movements,” he says.

Of course, it’s only natural for portfolio managers and do-it-yourself investors to adjust their portfolios in the face of rising rates. In theory, when interest rates climb, bond-proxy stocks – those stable dividend-paying companies that everyone scooped up when fixed-income yields plummeted after the recession – decline in value. Why? Because as solid as a utility company may be, it’s still better to buy a well-paying bond than a stock that’s subject to market ups and downs.

So, if you think rates are going to rise then selling interest rate sensitive stocks seems like a prudent move. Yet, many people have lost money by employing this strategy. Fortunately for Levine, while he got burned on his rate-reset preferreds, he didn’t touch his equity asset mix. He tries to have a diversified portfolio with money sitting in all sectors. More importantly, though, he’s looking for solid companies that can generate earnings growth in all economic conditions.

He likes human resources company Morneau Sheppel for that reason. It pays a solid dividend – it was 4%, but it’s now 2.8% as its stock price has climbed – but, for the most part, it’s continuing to grow revenues and earnings, he says. “You can’t predict where rates are going to go, but you’ve still done well because it’s a growing business,” he says.

If recent interest rate movements have reminded us of anything, it’s that it’s better to buy good companies (though even good companies can falter) or broad-based ETFs than to make big portfolio-changing predictions. If you do want to take the risk of betting on interest rates, then make sure you’ve prepared a mea culpa in case that prediction is wrong. “I don’t might if people laugh at me,” says Levine about his bet on rate-reset preferreds. “Lesson learned.”