Guarding against interest rate risk in Canada

Posted on March 12th, 2012.

When it comes to investing for income, things that appear simple can sometimes become a bit confusing, creating a “cloud of uncertainty” under which it is difficult to take action. No wonder many investors have historically flocked to simple investments like old fashioned GICs. Yup, many folks back in the “old days” would buy the five year term GIC, and when it came due they would roll it over and then over again. The trouble is that rolling over a five year or virtually any term of GIC has gone from being a low yielding but somewhat feasible strategy when interest rates were higher, to not much of a strategy at all at today’s interest rates. And so more and more people are looking for alternatives that pay decent income, but you can never have something for nothing, so a greater yield comes with the price of additional risk.

There are quite a few alternatives to simple GICs, some of them are:

  • Bonds
  • Convertible debentures
  • High yielding common shares
  • Real Estate Investment Trusts(REITs)
  • Preferred shares
  • Business trusts
  • Oil & Gas trusts

The above investments all have varying levels of risk and so this is clearly an area where expert advice is required. Common shares with high yields have a different risk profile than bonds for example. One type of risk that they all have in common is their susceptibility to changes in interest rates. The way one might react to a change in rates may be quite different from another though. I will explain so read on.

In my acclaimed book: InSync Income, The must Read Guide to Investing for Income in Canada, I introduced an entirely new way of categorizing income producing investments. I categorize them as follows:

Category 1: Income producing investments that have a maturity date where your money is meant to be repaid to you.

Category 2: Income producing investments that do not have a maturity date where your money is meant to be repaid to you.

Interesting? Why is that so important? Well, it is important because depending on the level and outlook for interest rates, it could be far more dangerous to own investments without maturity days at one time or another. Knowing this you can change the proportion of Category 1 versus Category 2 investments depending on the outlook for interest rates, among other things. I get into this quite heavily in my book, including examples of initial allocations of Category 1 and 2 – Chapter 2 The Solution, An InSync Income Portfolio is a must read for anyone near or in retirement.

Category 1 investments like bonds, convertible debentures, and some preferred shares provide the safety that comes from having a maturity date where you are meant to get your principal investment, or some other amount, returned. Also, you can choose between different terms to maturity – again depending on the current outlook for rates and other factors.  This type of investment will likely be less volatile than a Category 2 investment; this volatility will vary a great deal based on the credit quality of the issuer, type of investment, and outlook for the issuer and industry group, among other things.

Category 2 investments can be compared to very long term bonds. When you buy one there is a “current yield” based on the price you pay and the dividend or other payment that is made. If this payment stays the same, which is not a certainty, then you will continue to get that yield based on your purchase price. Any new investors will get a different yield if the price changes, higher or lower. Trouble comes when a change in interest rates makes buying safer investments more feasible and so the price of your investment may drop to adjust to the new interest rate environment. There are ways to reduce risk in this area. In my book I introduce an entirely new security analysis tool named the Dividend Anchor Score to help to differentiate between Category 2 investments with more or less volatility, and higher and lower distributions. I recently completed a study regarding the usefulness of the “DA Score” in collaboration with Hamdi Driss, a member of PHD research at York University’s Shulich School of Business. The study yielded compelling results regarding the usefulness of the score. Shulich has been named in the top ten business schools in the world, and number one in Canada by the Economist 2010.

DividendAnchorScoreStudyFall2011

There is a lot to know about the impact of interest rates and I think reading my book can help a lot. This is again an area where seeking the advice of an appropriate financial professional is advisable. Please do so prior to implementing a new, or making a change to any existing financial strategy. Invest with advice for best results.

Frank Weiler

The Income Investor’s Advocate

 

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