Rate hikes: Myths and facts

Interest rates in Canada are going higher. Just in case there was any lingering doubt, Bank of Canada Governor David Dodge made it crystal-clear recently. After a pause of almost a year, the new upward trend will begin with the Bank’s next rate-setting announcement in early September. How long it will last and how high our rates will go will depend largely on two factors: the performance of our economy and the strength of the loonie.

Higher interest rates are traditionally seen as bad news for bonds and income trusts but that’s not necessarily the case. Here are some of the myths and facts about rising rates that you need to be aware of.

Myth: Rate increases are bad for income investors.

Fact: Some of the most popular income securities like GICs should gradually increase the yields they are offering. Money market funds will generate better returns as short-term rates move higher.

Myth: All bond prices decline when rates rise.

Fact: Not so. Government bonds are usually most affected by higher rates, followed by higher-rated corporate issues. High-yield bonds arehe least vulnerable since their market price is determined more by credit risk than by rate movements. High-yield bonds are more affected by a slowing economy and the threat of recession, which may compromise a company’s ability to service its debt.

Myth. Rising rates will drive down the price of income trusts.

Fact. Some trusts are more vulnerable than others. REITs, utility trusts, and those carrying a large amount of debt are more likely to be hurt. Business trust prices are driven mainly by the performance of the operation. Any trust that is able to increase its distributions is unlikely to suffer a serious price retreat. Energy trusts and other commodity trusts are more affected by the world market price of the products they produce.

Myth: This is a signal to reduce fixed-income holdings.

Fact: Although bond prices have weakened recently, long-term bonds were the best-performing asset class in Canada in the first half of 2005. In the U.S., where rates have been rising since June 2004, mid- to long-term bonds have remained strong, thereby creating what Fed Chairman Alan Greenspan described as a “conundrum”. Possible reason: inflation expectations remain muted despite high oil prices. Inflation is the number one enemy of the bond investor.

The bottom line is that I do not recommend any drastic change in your portfolios in the light of the Bank of Canada’s move. I will continue to monitor the situation as it develops.