For the majority of the time we've worked with clients, interest rates in Canada were on a downward trend until they bottomed out a little over a decade ago. Managing the fixed income section of the portfolios was fruitful when prevailing rates were in the low double to mid-high single digits and falling. We collected a reasonable coupon and benefited from rising valuations on the bonds. In effect, we had two components available to provide us with returns, and both worked in our favour.

 

Since 2010, rates have been at generational lows. This removed the coupon component from the equation, but we continued to see some lowering of rates that put a little wind in our sails. 2022 was a different story, though, as the coupons were still very low, and the rising rate environment turned into a headwind for our valuations leading to negative returns from the historically positive segment of our portfolios.

 

The Bank of Canada has taken rates from below 1% to higher than 4% since March of 2022. We're not going to sugar-coat the impact of those moves on fixed-income investments; it hurt. Using a passive Canadian Bond ETF to show us what the market did over the past year, we saw a drop of 11-12%. OUCH!

 

Why did this hurt so much? Math is ruthless and unemotional. A 400bps rise off a 25bps base rate is a 1600% move. If prevailing rates were 8%, a 4% rise would be bad enough, giving us a 50% increase, but because we started from such a low base rate of 0.25%, the 4% rise has had a massive impact.

 

That's all well and good, and we've already felt that pain, so where do we go from here? How do we work within this new fixed-income environment to continue to create cash flow and provide consistent income in your accounts?

 

First and foremost, when dealing with a rising rate environment, Allan Bush and his team will want to shorten the maturities of the overall portfolio. Here's why. If we lock in a prevailing rate on a fixed-income instrument and rates increase, the principal value of our vehicle will go down. This decrease in value will reflect the fact that for the same principal amount, you could invest it in a similar vehicle for a higher rate of interest; therefore, our currently locked-in lower rate is worth less. The impact of this reaction to a rate increase gets greater as the length of the term increases. It's the opposite effect that helped us immensely over the past decade while rates were coming down.

 

If we keep our maturities on the short side, we will turn over the investments more frequently and reinvest at higher rates. It could help minimize the negative impact we spoke about above.

 

Taking the shortening of our maturity exposure to the extreme, floating rate securities bundled into a vehicle like an ETF can be an effective way to ride through a rising rate cycle. The securities have interest payments that track the prevailing treasury rates. While they aren't for everyone, as they don't hold any principal guarantees, they offer extreme liquidity, which can play a role in navigating an upward-rate environment.

 

We've been investigating the use of fixed-income alternative investments for some time, as yield has been very difficult to find in traditional investments we've used over the years. These vehicles have a return stream that is loosely impacted by the equity and fixed-income markets. They are still a potential spot to participate in higher cash flows through securities that will sometimes move at different times or in the same direction as the rest of your portfolio. We are very prudent when introducing new concepts to any portfolio. At Allan Bush Investment Team, we will only bring this idea up if it is an appropriate addition to your overall asset mix.

 

On the bright side, our cash flow will increase as rates rise. Will we revisit the historic low rates of the past decade? It is hard to say, but we don't expect it to happen again quickly if it does at all.