How To Protect Yourself If Interest Rates Rise

My late father-in-law was a patriotic Canadian who insisted he'd be willing to pay more for products made here. I remember he once bought a $143 garden bench from Canadian Tire and proudly pointed out the “Made in Canada” sticker. The next day I bought the identical bench, minus the Canada sticker, for $43 at Wal-Mart. Somebody at Wal-Mart must have misprinted the price, he said, but just to be sure, he went to the same store I'd gone to and checked out the garden furniture. The apparent pricing error had yet to be corrected, so my father-in-law took advantage of the evil U.S. retail giant's error and bought the bench, then returned his first one to Canadian Tire.

I needled him about the limits to his patriotism.

“I’ll buy a hockey sweater with the difference,” he said.

Improvements in communications and transportation means it costs less to make something in Hangzhou or Rawalpindi and ship it here than it does to have it made in North America, and that situation is likely to persist as long as people in places like China and India are willing to work hard for low pay. It’s not only manufactured products, either. Temporary foreign workers in the service industry are also willing to clean hotel rooms, serve coffee and perform other tasks for less than what those in developed countries will accept.

As long as developing countries can supply cheap labour, Western nations need not fear levels of inflation that inspire central bankers to raise interest rates. That must be good news for investors—at least for those who’ve managed to hold on to their jobs and have money to invest.

Eventually, however, something is bound to go wrong with this arrangement and inflation will return and with it, higher interest rates. I don’t know when this will happen, and neither do you nor anyone else. As for the “experts”, economists are no better at predicting the future than fortune tellers and are not nearly as colourful.

When inflation and interest rates do rise, most investors will suffer. If you own bonds either directly or indirectly through a mutual fund or an exchange-traded fund, the value of your holdings is almost guaranteed to fall.

Holding cash in a savings account may appear to protect against rising interest rates, but you won’t get paid much in the interim. Interest-rate futures and forward swaps seem to work, but I have yet to see either product offered for retail investors.

Laddered GICs

A laddered portfolio of GICs is the simplest way to protect yourself against rising interest rates, although GICs are relatively illiquid since most can only be cashed out on their maturity date. Buy five GICs with maturities ranging from one to five years, and when each one matures, reinvest it in a five-year GIC. The rate you’ll get on the new GIC ought to reflect current interest rates.

Right now, the most you can reasonably expect to get from a one-year GIC is about 1.5%, rising to about 2% for a five-year GIC. This is still much better than a savings account.

Cyclical Stocks

Another way of guarding against rising interest rates is to buy cyclical stocks like insurance companies, banks and brokerages that rise in value along with the prospects for economic growth and the resulting inflation and higher interest rates. An improving economy also means consumers will have more money for discretionary purchases such as appliances, cars, furniture and so on. In theory, the share prices of companies that make these products ought to improve along with the business cycle, hence the “cyclical” name. Unfortunately, buying cyclical stocks and waiting for the economy to improve involves correctly timing the market against millions of others trying to do the same thing.

Shorting REITs

Real estate prices move inversely to interest rates, so guarding against rising interest rates might logically involve betting against real estate. Real Estate Investment Trusts (REITs) always seem to plunge at even the slightest possibility of higher interest rates. You can buy ETFs from Proshares or Direxion that short U.S. REITs, but that’s another form of market timing and an especially risky strategy best left to day traders.

Real Return Bonds

A slightly better long-term strategy for Canadians involves buying real return bonds (RRBs), issued by the federal government and a few provinces, which are designed to give you a higher yield as the Consumer Price Index rises. The principal amount of the bond is adjusted to CPI every six months, so that when the bond matures, you get back your principal plus an inflation-adjusted amount.

Investors must report both the interest payments and the change in principal on their tax returns every year, so RRBs should be held in a registered account.

ETFs that hold RRBs

Individual investors are better served with exchange-traded funds that hold real-return bonds. The iShares Canadian Real Return Bond ETF (XRB/TSX), launched in December 2005, now has $456 million in assets and has been a solid performer over the past decade. Given that it has only seven holdings—almost all of them Government of Canada bonds—the fund’s management expense ratio of 0.39% seems a bit steep. A better choice appears to be the BMO Real Return Bond Index ETF (ZRR/TSX), a relatively small $40-million fund launched in 2010. The fund has achieved a respectable return of 7.36% since then, despite a 0.29% management expense ratio. ZRR’s entire holdings are made up of seven Canadian government real-return bonds with maturities ranging between 2021 and 2044.

Mutual funds also offer inflation/interest rate protection through a portfolio of real-return bonds, but all have high MERs or steep minimum investments, or both.

Floating Rate ETFs

Another type of exchange-traded fund designed to protect investors from rising rates are floating rate ETFs. As their name implies, these have generated slow, steady returns as rates have fallen over the last decade, but the real test will come when interest rates start climbing.

The iShares Floating Rate Index ETF (XFR/TSX), launched in December 2011, has achieved consistent annual returns ranging from about 1.2% to 1.5%, so a $10,000 investment made at inception and held for three years totals $10,476.44, with dividends reinvested.

The XFR fund has a regularly rebalanced portfolio of 49 floating rate bonds, with the bonds’ average maturity at 2.72 years and duration kept at a conservative 0.19 years. All this effort may well pay off if interest rates rise, but so far, the low-interest climate has kept its returns in check.

The Horizons Active Floating Rate Bond ETF (HFR/TSX) offers a floating interest rate that reflects short-term corporate bond yields. The fund, launched in 2010, is managed by Fiera Capital Corp. and carries a 0.40% management expense ratio.

In summary then, the best way to protect yourself against rising interest rates is also the simplest: a laddered portfolio of GICs with equal amounts maturing every year.

Epilogue:

The price differential I mentioned at the beginning of this article in no way suggests that items at Canadian Tire are generally more expensive than those at Wal-Mart, nor that Canadian Tire is more likely to stock Canadian-made products than Wal-Mart. We can say this, though: Over the past 10 years, Canadian Tire shareholders have been a much happier bunch than Wal-Mart investors, as the site longrundata.com shows that since the end of 2004, Canadian Tire investors enjoyed a total annualized return of 13.76%, nearly twice the 7.2% total return of Wal-Mart over the same period.

Richard Morrison, CIM, is a former editor and columnist at the Financial Post.