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Welcome to the CAPCORP Comment
For the week of March 20, 2017
An update on Canadian debt, the US Federal Reserve getting proactive on inflation, and President Trump’s first budget all made headlines last week. These stories, our regular market updates and a closing comment illustrating what happens to value bonds when interest rates change are presented in this edition of the weekly Comment.
Closing prices (In $US)
More debt, higher rates, and budget time
Equifax released an unsettling report last week. The total consumer debt for Canadians rose 6% to $1.718 trillion in the fourth quarter of 2016. Debt levels rose at the fastest pace in Toronto. Torontonians carry, on average, $20,857 of debt (excluding mortgages); this represents a 4.7% year-over-year rise. Debt levels in Vancouver were close behind as they rose 4.6% to $24,487. Equifax noted a "renewed appetite" for debt in Western Canada, with average levels rising 1.5% in Alberta and 2.6% in Saskatchewan from the previous year. A separate report from Statistics Canada showed the closely-watched credit market debt-to-disposable income ratio reached 167.25% in the fourth quarter compared to 166.75% in the third quarter. This latest data means households owe more than $1.67 for every dollar of disposable income.
The US Federal Reserve is trying to stay ahead of rising inflation. On Wednesday, it announced its third interest rate rise since the 2008 financial crash (this is the second rise in three months). This brings the base rate from 0.75% to 1%. Fed Chair, Janet Yellen, said a wide range of indicators show that the US economy is in good health, allowing the interest rate setting committee to push rates back towards historically normal levels. Policymakers voted nine to one to raise rates. They set aside concerns regarding the impact of higher interest rates on consumer spending to confirm analysts’ projections that they are prepared to increase rates several times this year to keep a lid on inflation, as it rises above its 2% target level.
President Donald Trump unveiled a $1.15 trillion budget on Thursday. There will be an overhaul of federal government spending which slashes many domestic programs in order to finance a significant increase in the military as well as start payment on a U.S.-Mexico border wall. A $54 billion boost for the military is the largest since President Ronald Reagan's Pentagon buildup in the 1980s. Trump promises immediate money for troop readiness, the fight against Islamic State militants, and the procurement of new ships, fighter jets and other weapons. This comes at the expense of cuts to foreign aid as well as domestic agencies that had been protected by former President Barack Obama. Law enforcement agencies such as the FBI will be spared. The border wall will receive an immediate $1.4 billion infusion in the ongoing fiscal year. Another $2.6 billion is planned for the 2018 budget year starting Oct. 1. Trump's proposal covers only roughly one-fourth of the approximately $4 trillion federal budget, the discretionary portion that Congress passes each year. It doesn't address taxes, Social Security, Medicare and Medicaid, or make predictions about deficits and the economy.
There was very little movement in any of the major indices last week as budgets, increased debt and interest rate moves balanced each other out. The TSX dropped only 16 points last week to close at 15,490. The Dow added 11 points to 20,914 and the S&P 500 up a mere 6 points to 2,378. The Nasdaq experience more gains than all of them combined, up 40 points to 5,901.
There was a surprise drawdown in U.S. crude inventories. Data from the International Energy Agency (IEA) showed inventories fall 500,000 barrels to 529.1 million barrels last week. This helped stabilize the price of crude, which has been falling over the past few weeks. Oil closed up $0.29 per barrel to $48.72 per barrel. Gold was helped by the interest rate increase in the US, as it closed up $24.80 per ounce to $1,228.90 per ounce. The Canadian dollar was also helped by the rate increase; it was up $0.0071 to $0.7493.
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Bonds and rising interest rates
When interest rates move, so do the price of bonds or bond funds. Fed Chair, Janet Yellen’s announcement last Wednesday (that the US is raising interest rates by 0.25% to 1.00%) naturally has investors asking how will this affect their fixed income investments? This week we explore what effect interest rates have on bonds.
As a quick review, the relationship between bond prices and interest rates are like a teeter-totter; when interest rates move up, the value of a bond or bond fund goes down. When interest rates drop, the value of a bond goes up. For example, say an investor has a bond (or bond fund) valued at $100, which is paying them 2% per year for the next 10 years. The Bank of Canada comes out saying that interest rates are going up, and as a result the new 10 year bonds (priced at $100) are paying 3%. Would the investor rather own their bond paying them 2% interest per year, or the new one at 3%? The answer is 3%, of course.
This results in the bonds at 2% being sold (which causes their price to drop), as the new ones at 3% are bought. The price of the 2% bond will continue to drop until its value at maturity equals that of the bond paying 3%. Without getting into a discussion on future value and present value of bonds, the bond at 2% might go down to $90, so that when it matures, the 2% interest plus a $10 gain in the value of the bond (rising from $90 to $100 at maturity) would be the same as if the investor received 3% interest all along. The bottom line is this: interest rates went up, so the value of a bond dropped. The opposite is also true; had interest rates dropped, the value of the bond would have gone up.
Since interest rates just went up in the US, what is going to happen to existing bonds and bond funds? While the Fed increasing rates is significant (ie. the reasons for rates rising is more important than the rate itself), it doesn’t mean rates overall will rise dramatically. It also doesn’t change the important role bonds can play in a portfolio. If a portfolio is properly diversified and matches the investors’ goals, time horizon, and financial circumstance, then small moves in interest rates should be of little concern.
In theory, if rates rise it could cause the value of a bond fund to fall (as illustrated above). In practice, even in a rising rate environment, bonds may still perform when they are needed. For example, they may rally at times when stocks fall (in the event of a crisis, economic slowdown, or other unforeseen event). For long-term investors, rising rates may help bond fund performance. If rates go up, the prices of bonds should drop; however, that’s not where the story ends. In a portfolio of bonds, the income from new bonds will be higher after rates rise, providing the potential to more than offset price losses over time—if one stays invested.
Remember, a bad day for bonds is not the same as a bad day for stocks (ed. note: that one is for you, Robert). In other words, when bonds experience losses, they aren’t like the losses that are experienced by stocks. Investment-grade bonds have historically tended to suffer smaller losses than stocks, and they rarely post losses over longer time periods. Performance varies greatly for bonds of different credit qualities. Even during the worst bear market for bonds, the 40-year period of rising rates from 1941 to 1981, the worst one-year loss for the Barclays U.S. Aggregate Bond Index (a broad index meant to track investment-grade bonds) was just 5%. Over a five-year period, bonds never even posted a loss.
With the prospect of rates continuing to move upwards there is a temptation to move out of bonds and into cash or other asset classes. Be aware, hiding like that (a.k.a. market timing) may be costly. The investor may avoid the risk that rising rates hurt the value of the bonds in their portfolio, but what about inflation? Over time, a broadly diversified index of U.S. investment-grade bonds —the Barclays U.S. Aggregate Bond Index— has produced positive returns after accounting for inflation far more frequently than cash. Moving out of bonds means the investor will have to choose the right asset class(es), and be right both times on the move: when the bonds get sold as well as when to buy them back. Many get one, but rarely does an investor get both on a consistent basis.
It has been a long time since investors faced a period of rising rates, and an equally long time since investors have asked, “How can the value of a bond go down?”. Be aware the value can go down, as can any other investment that isn’t a GIC. It’s not about having or not having bonds in a portfolio; it’s about making sure there is an appropriate number of bonds in a portfolio. Generally bonds will play a role in most portfolios, regardless of the rate environment. Happy Investing.
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