Over the past 40 years, interest rates have generally been descending. While there have been a few small variations along the way, this has been the overall trend. Years ago, you could own a long-term bond or an annuity and receive a much higher return than you can today.
In March 2020, the Government of ÎÚÑ»´«Ã½’s long-term bond rate fell to 0.71 per cent — a historic low. Over the past two years, we have seen longer-term interest rates gradually climb from these historic lows. The Bank of ÎÚÑ»´«Ã½ has already raised interest rates by 25 basis points and has up to six more rate hikes forecasted.
That being said, it is safe to say that retirees cannot conservatively earn the same amount of interest income as they historically have been able to with fixed income investments. Gone are the days of purchasing high interest paying bonds and living off interest income.
When we are in an environment where rates are rising, as they currently are, anyone that has bonds that are longer-term will lose value on those bonds. The days of having interest rates decline and gains on bonds are done for a while.
When rates are already at historic lows, they only have one direction to move, which can provide a challenge to investors now. They either choose to have a short duration and earn a low yield on their money, while the original purchase price of the bond could decline by more than the bond itself is yielding. If they choose to go longer term, they will get a little bit more money, but are likely to incur losses on the bond prices once interest rates go up. It is a lose-lose situation when interest rates begin to rise for bonds.
One question we have been asked many times recently is why existing bonds decline in value when interest rates rise, and vice versa. This article aims to illustrate to those investors who are not familiar with bonds how the inverse relationship between bonds and interest rates work.
To illustrate this inverse relationship, we will use two long-term Government of ÎÚÑ»´«Ã½ bonds with a face value of $100,000. Let’s assume Bond No. 1 was issued one year ago with a coupon rate of 1.80 per cent, and Bond No. 2 was issued today with a coupon rate of 2.50 per cent.
Unlike common equities, once the coupon of a bond is set it does not change. When bonds are initially issued, they have a par value of 100 and will mature at their par value of 100.
Throughout the life of a bond, it will trade at either at a discount (below 100) or at a premium (above 100). All else being equal, if current market rates are higher than the bond’s coupon, it will trade at a discount. If current market rates are lower than the bond’s coupon, it will trade at a premium.
One way I like to think of it is this: Say an investor is selling a bond on the open market with a coupon rate of 1.80 per cent, but I could go and purchase a new bond for 2.50 per cent. In order for me to buy the bond from the investor, they would need to entice me by selling that bond at a discount to compensate for the difference in interest rates.
Going through the calculations will also help with understanding the inverse relationship of bonds. The below calculations are overly simplistic and do not factor in the time value of money or taxation items, both of which are important concepts in bond valuations. The time value of money is the notion that a dollar today is worth more than a dollar tomorrow. The calculations below would be different if these items were factored in.
Bond No. 1 pays income of $1,800 per year ($100,000 face value x 1.80 per cent). For a 30-year bond, this equals $54,000 (30 x $1,800) in total income during the full term.
Bond No. 2 pays income of $2,500 per year ($100,000 face value x 2.50 per cent). For a 30-year bond, this equals $75,000 (30 x $2,500) in total income.
Bond No. 2 will pay $21,000 more in interest than Bond No. 1 ($75,000 - $54,000). In order for someone to sell Bond No. 1 today they would have to accept a price of 79.00 par value, or $79,000 ($100,000 par value - $21,000 difference in interest).
The second buyer of Bond No. 1 would purchase the bond for $79,000 then receive $100,000 at the end of the 30 years. The second buyer of Bond No. 1 would have a capital gain of $21,000 plus interest income of $54,000 which would equal the $75,000 in interest income that the holder of Bond No. 2 receives.
The number of years that a bond has before it matures may be referred to as “term” or “duration.” The longer the duration of a bond, the more it will fluctuate in value if interest rates change.
Let’s use Bond No. 1 and No. 2 again but assume that the term is 10 years and not 30.
Bond No. 1 pays income of $1,800 per year. For a 10-year bond, this equals $18,000 (10 x $1,800) in total income during the full term.
Bond No. 2 pays income of $2,500 per year. For a 10-year bond, this equals $25,000 (10 x $2,500) in total income. Bond No. 2 will pay $7,000 more in interest than Bond No. 1 ($25,000 - $18,000).
In order for someone to sell Bond No. 1 today, they would have to accept a price of 93.00 par value, or $93,000 ($100,000 par value - $7,000 difference in interest). The second buyer of Bond No. 1 would purchase the bond for $93,000 then receive $100,000 at the end of the 10 years. The second buyer of Bond No. 1 would have a capital gain of $7,000 plus interest income of $18,000 which would equal the $25,000 interest income that the holder of Bond No. 2 receives.
The loss on the value of Bond No. 1 incurred in the 10-year example is $7,000 after one year, which is significantly lower than the $21,000 loss on the 30-year bond. Investor No. 2 only lost $5,200 if the interest income of $1,800 received in the first year is factored in ($7,000 - $1,800 = $5,200).
When investors believe that interest rates may rise, one strategy is to execute a switch trade and simultaneously sell longer term bonds and purchase shorter term bonds. The downside to this strategy is that short-term bonds have lower current yields, and rates may not rise. Investors shifting to shorter term bonds will sacrifice a lower yield today to lessen the risk of an even larger decline in value of the bonds if interest rates rise.
The question then arises as to what is the best asset allocation? Many common shares have dividends that far exceed the interest income that bonds are paying. One favourable element of common shares is that you also have the growth component with the share price. In the majority of cases, the appreciation of the share price exceeds the dividend income. Some more growth-oriented names have purely price appreciation of the shares, and don’t pay any dividends.
If a client tells us that they have no cash flow or withdrawal needs from their portfolio, then having the majority of the funds invested in equities for the long run may be the best decision (provided they have the right risk profile). Even if a client does have stated cash flow needs from their portfolio, these funds can be set aside in a cash equivalent, and the remaining funds invested in equities.
To illustrate, we will use a recently retired investor named Susan.
Susan has $2,000,000 invested in our Moderate Growth Model Portfolio. The fixed income portion of her portfolio is 20%, or $400,000, which is currently yielding 3.0 per cent. Annually Susan is currently earning interest income of $12,000.
If interest rates rise to the point where Susan can earn 5.0 per cent on her corporate bonds, then Susan is clearly a winner in the long run as her annual income jumps up to $20,000. For Susan to benefit in the long run with rates rising, it is important to ensure that she does not incur a significant loss on her existing bond portfolio in the short term.
After a thorough discussion with Susan, we formulated some trade recommendations. We sold her longer-term bonds and reduced her overall fixed income by ten per cent. With the proceeds from selling the fixed income, we allocated some to increasing cash and the remainder to equities.
Now that she has reached retirement, Susan wishes to take $5,000 a month from her portfolio to supplement cash flow from her pensions. We added a “wedge” for Susan, which is 12 to 24 months worth of cash flow, set aside in cash equivalents. For Susan, this would be $60,000 to $120,000 (12 x $5,000 to 24 x $5,000).
We explained to Susan that the downside to increasing cash is that it currently earns less than one per cent. After Susan pays the 30 per cent tax on the interest income, her after-tax rate of return is significantly lower than the rate of inflation so her purchasing power is immediately eroded. On this portion of Susan’s portfolio, she will not be earning a real rate of return; however, Susan understands that this is intended to be a shorter-term strategy. In managing risk, we feel that in times like this, a small after-tax return would be better than a negative return on Susan’s longer-term bonds if rates rise.
As Susan requires income from her investments, some of the proceeds from selling her fixed income went to purchase lower-risk dividend paying equities that can help to keep pace with inflation. Susan was pleased that these trades increased her after-tax rate of return once the dividend tax credit was factored in. The potential for the portfolio’s value to increase through capital gains was also appealing.
The downside that needed to be weighed is that equities and the stock market could decline. Additionally, with more invested in equities, and less in fixed income, Susan will see increased volatility with her portfolio from day-to-day. However, Susan takes comfort in the fact that she has cash flow set aside for the next one to two years so she will not be forced to sell an equity at the wrong point in the market cycle.
In other instances, we have clients reduce their fixed income down to zero per cent and convert to a 100 per cent equity portfolio. We still set aside one to two year’s worth of cash flow requirements from all accounts (including non-registered, Registered Retirement Income Fund, etc.). Their Investment Policy Statement is updated to reflect these changes.
My old textbooks used to suggest that your age should be the per cent of your portfolio you allocate to fixed income. For example, at age 65, you would hold 65 per cent fixed income. The life expectancy in older textbooks was shorter than the average life expectancy today with medical advancements. As a result, people must plan for a much longer retirement and require growth during this period to maintain their desired lifestyle when inflation levels are this high.
Having 65 per cent of your portfolio yielding less than three per cent and declining in value in the short-term is not a prudent move. We have many clients who now have 100 per cent equity in retirement, keeping their cash flow for the next two years readily accessible. This allows them to invest in good quality equities which pay a dividend that can keep pace with the current levels of inflation we are seeing, and the share price will appreciate over time.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email [email protected], or visit greenardgroup.com.
