Take your lead from the key central banks
Keith and Kevin Greenard
Province
Most people benefit if they make a correct projection on the direction of interest rates.
This is easily illustrated when you are deciding on either a variable- or a fixed-rate mortgage.
If you feel interest rates are going down, or are staying close to current levels, then the best option is likely a variable-rate mortgage. If you feel interest rates are going up in the near term, then locking in with a fixed-rate mortgage may save you interest costs over the term.
Central banks in the U.S. and Canada announce changes to interest rates on predetermined dates. In Canada, there are eight specified dates during the year.
Central banks may also take action between fixed dates, although they would exercise this option only in the event of extraordinary circumstances.
By the time the predetermined dates arrive, most economists have a pretty good idea what the change will be. What is really important is listening to the words the U.S. Fed chairman or the governor of Canada’s central bank says about economic conditions and the outlook for future interest-rate changes.
When central banks seek to stimulate the economy, interest rates are lowered to encourage more borrowing and spending. Interest-rate changes are generally tied to economic conditions.
If conditions are improving, rate increases are more likely. If deteriorating, then interest-rate cuts (if possible) are more likely.
So how does all this economic jargon affect investors? Some investments are more likely to fluctuate in value than others as interest rates change. We have illustrated a few scenarios:
n Bond prices: These change inversely to fluctuations in interest rates. If rates go down, existing bond prices rise. If rates go up, bond prices decline. Interest rates are at historic lows now. As rates go up, the price of your existing bonds may decline in value. If interest rates are increasing, that is generally a sign that the economy is improving. If the economy is improving then investors are generally better off in equity investments.
n Short Term versus Long Term: Investors with low tolerance for risk should always hold a majority percentage of fixed-income-type investments (bonds, guaranteed investment certificates, term deposits, deposit notes).
What should fixed-income investors do if they feel interest rates are likely to change? If you feel interest rates are likely to increase, the focus should be on short-term maturities, being five years and under. If you feel interest rates will decline over the long term, you may profit from extending your maturity dates beyond five years.
All investors should look at the maturity dates of bonds. If all bonds are long term and interest rates begin increasing, then you will likely see a decline in the value of your long-term bonds. The No. 1 thing to note is that the longer the duration (time to maturity) the greater the volatility when rates change.
n Preferred Shares: Not all preferred shares are created equal. Hard retractable preferred shares have a set maturity date and fluctuate less with changes in interest rates. Perpetual preferred shares have no legal maturity date and are very susceptible to changes in rates. The higher the coupon on the perpetual preferred the less volatile it will be to changes in interest rates.
n Call Features: Unfortunately, most call features benefit the issuer, rather then you, the investor. You should monitor the call dates and the likelihood of it being called. Structured products, fixed income (Tier 1 and Tier 2), and preferred shares are examples of investments with call features. In some cases, the market anticipates the investment to be called. It is best to speak with your adviser about whether your investments have call features.
n Timing and Magnitude: Interest rates are currently at historic lows in the U.S.and Canada. Timing is the toughest part when it comes to projecting interest-rate changes. It really comes down to further projections. When will they change? How fast will the change occur? What will be the magnitude of the change?
By looking at the probability of different outcomes you will be able to map out a plan to minimize interest-rate risk.
Keith Greenard CIM FCSI and Kevin Greenard CA FMA CFP are Wealth Advisers of The Greenard Group at ScotiaMcLeod in Victoria.
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