Ask the Spud: Should I Fear Rising Interest Rates?

Q: Recently the bond market—and 40% of my Global Couch Potato portfolio—has dipped significantly. I understand swings like this occur from time to time, but with interest rates moving higher would it be wise to decrease the percentage in bonds to say, 20%? Or maybe temporarily stop my monthly contribution to bonds and instead put it in equities? — C.P.

I’ve received some variation of this question almost every day since interest rates began to spike in May. The unit price of the iShares DEX Universe Bond (XBB), which tracks the most widely followed bond index in Canada, is down about 5.5% on the year, and it could fall further if rates continue to tick upward.

It’s easy to understand the discomfort investors are feeling. After all, Canada has not had a year with negative bond returns since 1999. We’re accustomed to bonds delivering steady returns year after year, and we don’t know how to respond to a sharp decline in price. Our instincts seem to be to stop buying them, and maybe even to sell the ones we already own. But if you’re a long-term investor, that’s getting things exactly backwards.

Here’s one place Couch Potatoes can learn a lesson from dividend investors. If a company raises its quarterly payout and its stock price falls, dividend investors scramble to buy more shares. And why not? The higher yield means they’re paying less for all future cash flows. Tell a dividend junkie to stop buying shares (or trim his current holding) when the yield goes up and he’ll think you’re taking crazy pills. Yet long-term investors who want to stop buying bonds because rates have risen are using the same loopy logic.

Rising yields mean higher expected returns

Let’s say in July 2012 you put $1,000 into a 10-year Government of Canada bond. The yield at that time was about 1.6%, meaning if you held the bond to maturity that would be your annualized return. If today you have another $1,000 to invest, a 10-year bond would give you a yield of almost 2.8%. Surely that new purchase should make you feel better than the old one: after all, if you hold both bonds to maturity, the newer one will deliver an annual return 120 basis points higher.

Bond funds don’t have a maturity date, so their returns aren’t knowable in advance, but the principle is the same. As recently as this April, the DEX Universe Bond Index had a yield to maturity of about 2.1%, while today it’s over 2.9%. That means every dollar you put into XBB today has a much higher expected return than a dollar contributed six months ago. If you were willing to buy the fund in April, why would you avoid it today?

Make sure you’re in for the duration

There’s one extremely important caveat here. Any time you buy into a bond fund you need to make certain it’s appropriate for your investment goals. As I’ve written before, you should never hold a bond fund whose duration is longer than your time horizon.

Broad-based bond index funds—not only XBB, but its counterparts from Vanguard, BMO and TD—have a duration between 6.6 and 7 years. You should not use them to hold the down payment on the house you plan to buy next year, nor hold them in an RESP if your child is in grade 11. It is quite possible they will lose value over the next few years. (For the record, US Treasury bond data go back to 1928 and the worst period was a –0.4% annualized return from 1955 through 1959.)

But if you have a horizon of 15 or 20 years, or more, why are you worried about what might happen to your bond fund in the next 12 to 36 months? Even if you are gun-shy about short-term losses, shifting from bonds to stocks clearly increases that risk.

If you’re in the accumulation phase of your life, rising interest rates will cause some short-term pain. But in the long run they’re a good thing—as long as you stick to your strategy of buy, hold and rebalance.

61 Responses to Ask the Spud: Should I Fear Rising Interest Rates?

  1. Rob September 22, 2013 at 10:26 am #

    If I am already holding ZAG as the 45% FI component in my own RRSP, are there any advantages / disadvantages to using a 50/50 combination of CLF / CBO, rather than a broad based bond ETF, as the 45% FI component of the one I am in the process of constructing for my spouse. Thanks.

  2. Canadian Couch Potato September 22, 2013 at 1:52 pm #

    @Rob: CLF/CBO has less maturity risk (the bonds are shorter term) and a bit more credit risk (more corporate bonds). But overall holding both gives you a decent fixed income exposure, not dramatically different from ZAG.

  3. Oldie September 23, 2013 at 11:12 am #

    @CCP: In your answer to @GeoEng51 you said

    “But you will want to start thinking about a strategy for drawing down your portfolio after you stop earning an income.”

    In the context I see that this was a preamble for the next couple of sentences warning him not to have the asset portion required for liquidation within 4-5 years in bonds or equities.

    But @GeoEng51 has mentioned he has significant non-RRSP assets. Admittedly we don’t know his whole picture; but depending on the specifics, is it reasonable to speculate that following cessation of employment he may not actually need to draw down his portfolio at all?

    IF he had sufficient non-RRSP assets and IF he was comfortable holding a sufficient bulk of these assets in Canadian Equity ETF, and IF the resultant overall asset mix analysis remained in the prudent range for his time horizon, might the dependable dividends from the Canadian Equity portion provide a sufficient annual income, taxed extremely favourably, to avoid or at least mitigate the need to draw down his portfolio? I suspect a sizeable number of prudent (i.e. reading this blog!) Canadian investors in his age demographic might be in this same position.

    This might keep his portfolio intact until the time of forced RRSP payout required yet another strategy to maximize efficiency.

  4. ipmonty October 4, 2013 at 12:22 am #

    I have read many of your posts and e-series funds was the starting step when I started building my portfolio.

    I am still maintain my original assert-allocation (I am a new grad, so have kept only 20% fixed income), but am putting the money away in savings account instead that giving the same yield as a 10 year bond. This way, I do have the money left to re-balance, but don’t have to take the downside risk on the rising interest rate.

    In this condition, does going with bond route still make sense?

  5. dael November 25, 2013 at 12:40 pm #

    Hi,
    Thanks Dan, for your advice re: getting out of active managementD I have just transferred my portfolio out of active management to a discount broker, and have set up a TFSA and a non-registered account. I am wondering if I should open an RRSP for certain investments. I have never contributed to an RRSP, so I have room. My pre-tax income post-retirement will be the same or slightly more than it is now. (30,000-36,000) Thanks,
    Dael

  6. Canadian Couch Potato November 25, 2013 at 2:28 pm #

    @dael: Unless you expect your post-retirement income to be lower than it is now, it typically doesn’t make a lot of sense to contribute to an RRSP. Certainly you should max out your TFSA first.

  7. David August 11, 2014 at 4:50 pm #

    Hi,
    Can you explain the rationale for creating an ‘annuity,’ by buying index stocks,” using the money you would otherwise put into bonds, thus bringing your bond allocation down by a third.Thanks,
    David

  8. Canadian Couch Potato August 11, 2014 at 6:41 pm #

    @David: Did you read about this strategy somewhere specifically that you could point me to? I’m not sure I understand what you’re referring to when you say “creating an annuity by buying index stocks.”

    Buying an annuity (like having a defined benefit pension) would likely change your asset allocation, though it’s not as simple as saying you should “cut your bond allocation by a third.” This may help:
    http://canadiancouchpotato.com/2014/04/14/ask-the-spud-is-my-pension-like-a-bond/

  9. Gavin McDonald April 30, 2015 at 10:47 am #

    Hi Dan,

    Thanks for the informative article. I have been following an index strategy now for about 12 years for my retirement and more recently, my children’s RESP account. Currently my oldest son is six and therefore it will be about 11-12 years until we need to access the RESP. As this time is longer than the duration of XBB, this is where I keep the bond component. My plan is that when the time to needing to withdraw equals the duration of XBB, I will no longer contribute to XBB and instead use something else for my fixed income such as XSB. However, I will not sell what I already have in XBB until withdrawal knowing that all money contributed has at least the duration to offset any interest rate increases. I would appreciate if you could let me know if the strategy in the last sentence makes sense.

  10. Canadian Couch Potato April 30, 2015 at 10:58 am #

    @Gavin: The first point to understand is that your time horizon is always getting a little shorter, but the duration of your bond fund is gong to stay more or less the same. So you can’t really plan for future liabilities with any precision the way you can do with an individual bond. If you buy a 10-year bond, then next year it’s a 9-year bond. But usng a fund like XBB is a little like buying a 10-year bond and selling it every year to replace it with another 10-year bond.

    In the case of an RESP, however, it’s not necessarily to plan things too precisely. My suggestion would be to just decrease the risk in your RESP gradually once you’re about four or five years from your son starting university by adding a cash component to the portfolio. By the time he graduates high school the RESP should be all cash or GICs, in my opinion.

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