Earlier this month, the Bank of Canada announced it was raising its key interest rate from 1% to 1.25%, with Governor Stephen Poloz indicating that Canadians should get comfortable with the possibility of more hikes to come. Canada’s largest financial institutions have since followed suit with similar increases in their key rates.
What does that mean?
Following the 2008 financial crisis, central banks lowered their rates to help stimulate the economy and pull us out of recession. Now that many economies are back on stable footing, the banks are returning to higher lending rates that support a higher growth economy. The Bank of Canada has pointed to solid economic reports, including strong employment and GDP growth, to justify last week’s modest increase.
This doesn’t mean that if you take out a loan tomorrow it’s going to be 0.25% higher than it would have been a week ago. The key interest rate is not the rate you as an individual get at your bank. This is a short-term rate, often referred to as the overnight rate, that major financial institutions use when lending to one another.
How could my investments be affected?
While parts of the bond market can do well when rates rise, the generally accepted investment advice is that when interest rates go up investors should avoid buying publicly-traded, long-term bonds. Let’s take a look at both.
In a rising interest rate environment, the value of publicly-traded bonds goes down. This is because there is an inverse relationship between a bond’s price and its yield.
It’s simpler than it sounds.
Say you invest $1000 in a newly issued publicly traded bond that promises a 4% yield. Next week, rates suddenly increase by a 1%. Now, new bonds issued are offering a 5% yield. If you want to sell your 4% bond, you’ll have a harder time as investors clamour for the higher rate. In fact, in order to sell your bond, you would have to do so at a discount (for less than the $1000 face value that you initially paid) in order to sweeten the deal and bring the value of the 4% bond up to the same value of the new 5% bonds.
Longer vs shorter-term bonds
As for avoiding long-term bonds in a rising interest rate environment, the logic is simple. Longer-term bonds are more sensitive to rate hikes. Purchasing a 2% bond with a 10-year-term when rates may rise, could mean selling at a large discount and/or missing out on a future 2.5% or 3% bond and potential profits down the road.
It’s important to note that rate changes made by the Bank of Canada take time to ripple out and impact the broader market. For example, the Bank of Canada’s 10-year bond was trading at 2.167% prior to the 0.25% rate hike. A week later, it was trading at 2.22%. In other words, the 10-year bond only moved by 0.05% following the increase.
A bond investment strategy when interest rates rise
Another potential option for some investors looking for the stability of a fixed-income product is investing in private bonds. Unlike publicly traded bond securities, private bonds don’t fluctuate in value. Risks aside, bondholders can expect to be repaid their principal in full upon maturity as well as the promised interest payment.
Private bonds, like other uncorrelated investments, can be used by investors as part of a diversification strategy -- protecting a portion of their investment portfolio from general market fluctuations.
Because private bonds require investors to sacrifice some liquidity -- bonds must be held to maturity -- investors are often rewarded with what is called a “liquidity premium,” in plain language higher interest rates and profits. This can, in turn, provide some cushioning from central bank rate hikes.
To illustrate, CoPower Green Bonds are a private investment opportunity accessible to individual investors. CoPower Green Bonds, with a 5-year term and a 5% interest rate, provide a solid cushion as other bonds such as government bonds inch higher to the 2% range. While we can’t predict or advise on future interest rate trends, it’s unlikely that bond rates in the broader market would rise to a point where opportunity cost would become a concern. And as these bonds are not traded on a public exchange, investors can rest easy knowing that what they see is what they get.
Jennifer Macdonald is CoPower's Manager of Impact Investing. With a ten-year career in investment banking and portfolio management, Jennifer is our resident investment and finance expert. Chances are if you’re planning on investing in our Green Bonds you’ll end up emailing or on the phone with her at some point.
Lauryn Drainie is CoPower's Manager of Marketing and Engagement, helping build a community of individuals investing for profit and planet. Lauryn's passion for fighting climate change stretches back over a ten-year career in community and online organizing.