Q&A: Confused About Rates

If interest rates aren’t going up for the next few years, why are bond funds losing value? Gordon Pape gives his answer.

Q – This morning on the radio, I heard an expert from Scotiabank proclaim that interest rates won’t begin to increase until 2016. We have money invested in the TD Canadian Bond Fund, which is decreasing in value. If interest rates haven’t increased, why are bond funds losing value? Are they not supposed to go in opposite directions? It almost feels like we’re being scammed by the big banks. I would like to hear your thoughts about this. – John M.

A – A lot of people are struggling with this. The problem stems from the fact there are two types of interest rates. One is the policy rate, which is set by central banks, such as the Bank of Canada and the U.S. Federal Reserve Board. Those rates have been artificially low since the crash of 2008-09 in an effort to stimulate growth. The Fed is on record as saying its target rate will remain at 0.25% until at least 2015 and some experts believe it will be 2016 before the economy is healthy enough to begin raising rates again.

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The second type is commercial rates, which are driven by traders in the bond market and the major banks. Back in May, fears arose that the Fed might taper off its program of quantitative easing (QE), which currently involves spending $85 billion a month on bonds and mortgage-backed securities. QE has the effect of keeping interest rates low because of all the new money being pumped into the market each month. Concerns over what would happen when the program ended drove bond prices lower, thereby increasing yields and effectively raising rates. This explains why your bond fund (and all others) has slipped in value.

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