After keeping rates at historic lows for the past decade, the Bank of Canada raised interest rates in 2017 and hinted that, with the economy close to full capacity, more rate increases may be in the cards.1 Rising rates are most obviously felt in higher mortgage rates and borrowing costs, but they can also affect an investment portfolio. Here’s what you need to know.
Winners and losers in the rate game
With Canadian economic growth picking up, the consensus is that the Bank of Canada will continue to raise interest rates. Indeed, the Bank suggested that the economy could be running at full capacity by the end of 2017, making the case for additional rate increases in 2018.
There are winners and losers in a rising interest-rate environment. The financials sector may see an uptick because rising rates often point to strength in the economy, and a stronger economy may result in fewer loan defaults, along with higher spreads on what financial companies pay out on savings accounts and what they earn on their government and corporate bonds.
In addition to the financial sector, the industrial, consumer discretionary, and technology sectors of the market typically benefit from rising rates.
Areas of the market that are more sensitive to higher rates — such as telecommunications, utilities, real estate investment trusts, and fixed income — may experience higher volatility.
How mutual funds are affected
How your fund holdings are affected by rising rates depends on a number of additional variables. Here’s a rundown, by fund category.
Money market funds.
Funds that hold highly secure interest-earning securities are clear winners in a rising-rate environment. If you’re parking cash in a money market fund, you’ll enjoy higher rates on your savings.
When interest rates rise, the price of previously issued bonds falls. The longer the term of the bond, the more marked the price decline. At the same time, however, newly issued bonds offer higher yields.
The effect on bond funds, however, is more complex, and will vary depending on the types of bonds held and the fund manager’s ability to adjust the fund’s holdings. Moving to shorter maturities, for example, can help mitigate the effect of rising rates.
Regardless of the effect on the fund’s unit price, it’s important to remember why you have bond funds in the first place — to provide stability and generate regular income.
Dividend funds that focus on utility, pipeline, and telecommunications companies may experience greater volatility as those companies will see increases in their borrowing and financing costs in a rising-rate environment. Funds with a significant weighting to financial services companies, on the other hand, may experience less volatility and could even benefit.
The Bank of Canada is raising rates against a backdrop of stronger economic growth, and an improving economy can boost corporate profits — which is one of the biggest factors supporting equity markets. Growth-oriented mutual funds with a higher weighting in industrials, financials, and technology companies usually stand to benefit the most.
Maintain your focus
After such a long stretch of stable or declining rates, it’s common for investors to become apprehensive at the first hint of increases. Remember, however, that we chose the funds for your portfolio based on their combined ability to help you reach your long-term goals regardless of interest rate or market ups and downs.
That’s why it’s important to maintain your current investing regimen. If you invest automatically, for example, continue to do so. If you’re concerned that rising rates may affect your personal borrowing cost, talk to us. Effective debt management is an important part of your investment plan and just one of the many components of our service to you.
1 Bank of Canada Monetary Policy Report, July 2017.
Larry Kleinmintz, R.H.U., T.O.T., M.D.R.T.
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