Interest rate alert

As we enter 2006, it appears that the number one concern for investors in the coming months will be rising interest rates. Depending on how high they go, the impact on your personal finances could be significant.

The Bank of Canada raised its target rate again by a quarter-point last month, to 3.25 per cent, and signaled that more hikes should be expected in 2006. The reason is simple: our economy is strong (although the benefits are unevenly spread across the country), unemployment is low, and inflation is again perceived as a threat after hibernating for many years.

The upward pressure on rates will be gradual, but it will happen. The central bank has three rate policy announcements scheduled between now and the end of April and unless there is a sudden and dramatic shift in the economic climate look for the overnight rate to be at 4 per cent by May 1. That would push the prime rate at the major banks to 5.75 per cent, which would be the highest we have seen since 2001.

If the scenario unfolds in this way, it will have an impact on a wide range of securities, from GICs to income trusts. Here’s what to look for.

GIC rates will edge higher.</trng> We haven’t seen a lot of movement yet in GIC rates even though the Bank of Canada has announced three quarter-point hikes since September. The major banks are still offering less than 3 per cent on five-year GICs which implies a negative real return in non-registered portfolios once taxes and inflation are taken into account. But the returns should move higher through 2006. If the BofC follows through with its warning, we could see big bank five-year GICs paying 4 per cent or more by the end of the year.

The investment implications are clear. Under no circumstances should you lock in a GIC for five years at the current rates. If you have a GIC coming due in 2006, send a letter to your financial institution with specific instructions that it not be rolled over for another term (otherwise they will do it automatically). If you must invest for a longer term, choose a GIC that employs a laddering strategy. These roll over 20 per cent of the investment every year over a five-year period so that a portion of your money is being reinvested at current rates. Bank of Montreal recently announced what they call a RateOptimizer GIC that does this. Royal Bank calls theirs a Five-in-One GIC, but the principle is the same. Most other banks have a similar plan.

Bond prices will soften. Long bonds did extremely well in 2005 as the Scotia Capital Long Bond Index gained 13.84 per cent for the year, a robust showing that surprised almost everyone. It’s hard to see how that can continue into 2006 in the face of more rate increases from the Bank of Canada. Bond investors should therefore be cautious. Short-term issues with maturities less than five years out are the least vulnerable to market loss in a rising rate environment, although they are not immune.

This does not mean the bond market is about to collapse, but it would be unrealistic to expect it to do as well as in 2005. Over the 12 months to Nov. 30, the average Canadian bond mutual fund gained 5.44 per cent according to GlobeFund. My feeling is that the average for 2006 will be in the range of 4.5 per cent to 5 per cent.

Income trusts may weaken. Take a look at the yields of some of the most popular income trusts. You may be surprised. RioCan REIT is paying less than 6 per cent. So is Yellow Pages Income Fund. North-West Company Fund yields only 5.2 per cent. There are many others in the 5 per cent to 7 per cent yield range.

It doesn’t take a lot of imagination to figure out what will happen to these trusts as interest rates rise. Unless they are able to keep pace by increasing distributions, their market values will fall to reflect the enhanced risk they carry. If GIC rates move over 4 per cent, many investors will opt for the safety they provide over the uncertainty of income trusts if the yield spread is less than three percentage points.

The higher-yielding trusts probably won’t be affected to any significant degree unless rates take off. But they carry a lot more risk.

Cash will look better. Short-term securities will be the first to benefit as the Bank of Canada notches up rates. These include Treasury bills, bankers’ acceptances, money market funds, and even Canada Savings Bonds.

The pattern is already taking shape. Last spring, CSBs were paying only 1.55 per cent in the first year. Now the yield is up to 2 per cent.

At the start of 2005, three-month T-bills were yielding 2.52 per cent for big-ticket buyers. Today the rate is up to 3.46 per cent. In the past 12 months, Altamira T-Bill Fund, one of my Mutual Fund Update recommendations, showed a gain of 2.3 per cent. By this time next year, that number will likely be close to 3 per cent. Those aren’t princely rewards but the trend is clear. Cash-type securities will look more attractive and very conservative investors will put more money into them, especially within registered plans.

The bottom line is that 2006 will be quite different from 2005 from an investing perspective, with steady interest rate increases the dominant factor. Make sure you are prepared for this change and well-positioned to take advantage of it.

Adapted from an article that originally appeared in The Income Investor, a monthly newsletter that provides advice on selecting income securities and managing an income portfolio. For subscription information: