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I’ve been getting a lot of messages lately asking this question. Basically, people (including myself) are looking at their portfolios and seeing everything going up except bonds. They’re reading the news about interest rates being in the crapper, and they’re asking themselves “Why are we owning these things? All they’ve done lately is go down.”
Remember, the primary reason that bonds are used in an investment portfolio is that they act as stabilizers. They generally move in the opposite direction of the stock market, so when equities go up, bonds go down and when equities go down, bonds go up. This acts like a pendulum and keeps the entire system stable. So when people see bonds going down, they’re actually doing exactly what they’re supposed to. Not everything is supposed to go up at the same time.
However, one argument for changing our outlook on bonds exists, and that’s our outlook on interest rates.
Normally, guessing where direction interest rates are going to go is pointless, because not even central bankers know what they’re planning on doing. That decision is based on many factors such as economic outlook, inflation, and government policy, all of which change day by day.
However, right now interest rates are scraping the bottom of the barrel. Central banks around the world dropped interest rates off a cliff back in early 2020 and then started printing money in a frantic effort to keep the economy from imploding. For the most part, it worked (although many still-laid-off restaurant workers may disagree). We hit a short, sharp depression where economic activity ground to a halt as businesses were forcibly shut down because of the pandemic, but 12 long, painful months later, things are looking up again. Vaccines have been developed, shots are going into arms, cities are starting to re-open, and in all likelihood by sometime this summer or fall, some semblance of normal will have returned.
I’m not saying the return to normal will be smooth, though. All it takes is one nasty variant that the vaccines aren’t effective against and we’re all back to square one, but as of right now, it looks like we’re on the road to recovery.
And what that means is that the most likely direction of interest rates is up.
So if that’s true, how does that affect our bond strategy?
Investing in a rising interest rate environment is not a new situation. The last time we had to deal with this is back in 2017, which seems like forever ago. We could travel wherever we wanted and nobody had any idea where Wuhan was. It was a simpler, happier time.
A rising interest rate environment typically occurs as an economy recovers. Central banks gradually turn off the spigots of cheap money and allow interest rates to float back up. This way when the next recession happens, they have dry powder ready to deploy to stimulate the economy once again.
However, a rising interest rate can play havoc with your bond holdings because a rising interest rate makes bond prices go down. All of a sudden, the “safe” part of your portfolio starts to drop and look, well, not so safe anymore.
So here are three strategies that you can use to invest in a rising interest rate environment, as well as my totally subjective hot take on each.
As always, the opinions I express on each strategy are mine alone and should not be taken as financial advice. If you choose to implement any of them, do your research, make up your own mind, and own that decision.
Shorten Your Duration
This is the traditional advice for bond investors, and it has to do with how “long” your bonds are. Basically, the longer a bond is, the more affected its price is by interest rate changes. If you look at your ETF’s website, you can find a metric called the “duration,” which is a handy way of measuring the average length of your bond and its sensitivity to interest rate changes.
How it works is that if interest rates move one percent in either direction, the bond ETF will move in the opposite direction by this duration number. So for example, if we look at the Vanguard Total Bond Index page, we can see that it has a duration of 6.6 years, so if interest rates go up 1%, then the BND ETF value will go down 6.6%, and vice versa.
So when interest rates are dropping, you want to go long in your bond holdings because you’ll get more of an upwards boost in your ETF value. Conversely, when interest rates are rising (like now), you want to go short to lessen the negative impact. Vanguard offers short-duration bond index ETFs on both the Canadian (VSB) and the US side (BSV). You’ll give up a bit of income but you’ll more than make up for it in a lower capital loss once interest rates start to rise.
We’re actually planning on doing this to our Portfolio A bond holdings, but because central banks in both Canada and the US have pledged not to raise interest rates this year, we are planning on looking into this next year when we’re a bit closer to central bank interest rate hikes. I don’t want to give up my yield on these juuuust yet.
- Less capital losses as interest rates rise
- Lower interest rate
Up Your Credit Risk
Another way of getting yield in a low-yield world is upping your credit risk. This means pivoting away from super-safe assets like US treasuries and moving towards corporate bonds.
These bonds will still act as a stabilizing force in a portfolio, but will swing wilder than super-safe US treasuries because the risk level is higher. But in exchange, you will be getting a higher interest rate.
However, if you’re going to go down this route, be very careful to keep your corporate bond holdings at the BBB credit rating or above (known as Investment Grade). At this level, you’re mostly going to be getting bonds from financials like banks and industrials like energy companies. If you go below that searching for yield, your holdings will start to look more like this.
That’s a high yield bond ETF, and contains such champs as Caesar’s Entertainment (!), American Airlines (!!) and Carnival Cruises (!!!). Er…I wish these guys all the best, but I’m not touching a cruise ship company with a 10 foot pole anytime soon and neither should you.
Up here in Canada, we’re using an aggregate bond fund that also contains corporate bonds, and the yield spread between an aggregate bond ETF (VAB: 2.6%) vs. a corporate bond ETF (VCB: 2.8%) doesn’t make this trade-off worth it for us, but if I were American this would be a lot more appealing as the spread between the aggregate bond ETF (BND: 1.4%) vs a corporate bond ETF (VTC: 3%) is a lot juicier.
Vanguard also offers short, intermediate, and long-duration corporate bond ETFs as well, so you can really fine-tuning these first two knobs if you want.
- Higher yield
- Somewhat more volatile
Here’s where we get funky. Rather than invest in things that pay a fixed interest rate, why not go with something that pays a floating interest rate instead? Specifically, I’m talking about Preferred Shares.
Preferred shares come in all flavours, and you can buy ones that have a non-fixed coupon rate. That way, as interest rates rise, so will the income you get from these preferred shares, which will also boost its price as well since they’ve become more valuable.
Here in Canada, preferred shares tend to be structured as rate-resets, which means every 5 years they reset their interest rate as a spread relative to the 5 year government bond rate, so the preferred market in Canada is naturally a floating-rate investment. In the US, preferred shares are issued as both fixed and floating, so you have to specifically find an ETF that invests in floating-rate Preferreds to get these. VRP is an example of one of these ETFs.
We actually owned preferred shares for the longest time as part of our Yield Shield strategy, and I’m happy to report that even with all the craziness that happened in 2020, preferred share dividends didn’t get cut, so this makes two recessions that these things survived. But at the beginning of 2020 as part of our ongoing portfolio simplification, we sold off our Preferred Share holdings and moved it into the traditional bond index.
Now with interest rates looking like it’ll come back up, Preferred Shares are looking super attractive compared to bonds. They pay a way higher dividend (4.5% – 5%), the dividend will increase with rising interest rates, and the ETF will go up in value as well.
So you’re probably wondering, a higher yield AND potential upside? What’s the catch?
The catch is that Preferred Shares don’t behave like bonds. While bonds tend to be anti-correlated with equities, preferred shares are positively correlated, so you’re losing the stabilizing effect that fixed income normally has on your portfolio.
For that reason, we’ve decided that we’re not going to put Preferred Shares back into Portfolio A since lower volatility is still important to us for our main retirement portfolio. However, our risk tolerance for Portfolio B, which we use to invest money we’ve earned from this blog and our book, is much higher since we don’t need that money to fund our day-to-day expenses. By swapping out our bonds in Portfolio B with Preferred Shares, we’re juicing our income, making Portfolio B more tax-efficient, and setting ourselves up to participate in the upside when interest rates start rising. However, this will make Portfolio B behave more like a 90% equities/10% fixed income portfolio rather than the 75%/25% split it was before. We are making that decision consciously, so if something bad happens with this vaccine rollout and stock markets swoon again, we’re not going to freak out that Portfolio B is dropping more than Portfolio A.
The ETF we’re using for this is the BMO Laddered Preferred Share Index ETF (ZPR), in case you were curious.
- Higher Yield
- Will rise in value with rising interest rates
- Won’t act as a stabilizing force against equities
So there you have it. With interest rates in the crapper and an economic recovery hopefully on the horizon, these are the strategies you can use on the bond portion of your portfolio. Are you planning on doing anything to your investments? Let’s hear it in the comments below!
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