My approach for higher interest rates
Some time ago, I wrote about my investing approach for a prolonged low interest rate environment. I wrote, while low interest rates are good for a few reasons (including great borrowing costs), prolonged interest rates have some big drawbacks: they hurt fixed income assets like bonds and savings accounts and consequently hurt folks that are fiscally conservative.
With bond yields on the rise and possibly much higher going-forward I thought it might be interesting to share my investment approach for a rising interest rate environment. After my three steps are done, I’d like to hear from you about your plans…
Since our total debt comprises a modest car payment but also a fat mortgage, the first thing I’ll focus on as interest rates move higher is our mortgage debt; that’s our highest interest debt around 3%. We’ll continue to pay down our mortgage using lump sum prepayment privileges, maybe even make a few more lump sum payments than before if we can. If we keep after this mortgage beast we’ll be debt-free in 8 years. Having no debt burden will not only feel amazing but will provide my wife and I with some significant financial flexibility.
I’ll avoid making any major investments in bonds. As interest rates climb, bond prices fall and while falling prices (to make investment purchases) are usually a good thing; we have enough bonds in our portfolio. Instead, I’ll take the higher bond yields as they come and just reinvest the distributions paid by our bond holdings to add to our existing position every month. (I recall we’re DRIPping two bond ETF units every month).
Every month, I try and set aside about 5% of our net income for investment purposes. Last year, money saved was invested into a few Canadian dividend paying stocks and namely U.S-listed Exchange Traded Funds (ETFs). I’ve read a few articles that stated equity markets will falter after rate-hikes are announced because investors will react irrationally to the new the monetary policy. If that happens, that works for me since I like to buy my equities at cheaper prices.
As you have just read, we don’t have much to adjust when interest rates rise. Actually, some pretty boring plans lay ahead: paying down our highest interest debt (mortgage), keeping our bond allocation relatively steady and investing in the stock market when some stocks dive lower in price. Makes me think I’ve missed something important to do because it seems too simple to work.
What are your plans for higher interest rates?
Have you used that calculator on canadianmortgagetrends that shows your mortgage renewal risk? (mortgage stress test calculator)
I tried it with a 400k mortgage now, renewing in 1.5 years, with rates at 5.25%. It woul cost almost $500 more per month to service the loan.
Kinda scary imo. For now I will be eliminating 2 mortgages using the cheap mortgage rates so when come renewal, I can pay them out or the inpact of higher rates will not have much effect on our cash flow.
Yeah, those mortgage calculators freak me out. I would pass out if I had a $400k mortgage. I hope to kill our 6-figure mortgage in 8 years. I can only hope we can do it.
Smart man to eliminate the mortgage while rates are low. They can’t stay this low forever, can they?
I keep my bond investing to short term bonds to ward off some of the effect of rising rates. It’ isn’t perfect, but it works for me.
Very smart Jon, to keep your bonds short if worried about rising rates. If you intend to hold bonds for 20+ years, not too worry so much.
I think most good investment strategies work well no matter the interest rate environment you are in. It’s impossible to predict the timing and magnitude of a rise in rates so I like your plan of keeping your head down and ignoring the noise.
For those retirees or investors that need protection from large stock market losses, I think staying on the short to intermediate term in duration for bond holdings is the best bet whether rates are rising or falling. Much less volatility in this part of fixed income than longer maturities.
I agree Ben. I think the best investment plans are the ones that do not change/do not have to change that drastically.
I suspect when I’m close to retirement age, I will be in some short bond ETFs. That’s another 20 years though.
Thanks for the comment!
Question: If one feels compelled to add some bonds to one’s portfolio, to diversify and improve asset allocation, which bonds or bond funds would the readers of this newsletter recommend buying?
The Couch Potato people recommend to only own the following ETF’s:: XRB and XBB, or ZFM and ZCS. (ZCS is BMO short erm corp. bonds.)
Humm. Tough question to answer without knowing more details Helen. I have some favourites listed here:
Since my bond holding period is measured in years, not months, I don’t mind having longer bonds in our portfolio, even though I only keep a few.
If an investor has a short investment timeframe, I would suggest (although this is not a recommendation) short bonds. Also, I would suggest only holding a bond fund/ETF if you expect to hold it much longer than the bond durations. Example, people worried about interest rates rising, and getting out bonds, shouldn’t hold XBB. The XBB duration is around 6-7 years. If you’re not willing to hold your bonds for at least 6-7 years, probably 10-15 would be better, then you shouldn’t be in a product like XBB. This is because you’re going to sell your bond product and thus the holdings before they mature. Not smart.
The Couch Potato folks suggest a number of bonds. I’m not a huge fan of holding an assortment of bonds myself, so I prefer to either hold a med-long term product like XBB or go a bit shorter with something like XSB.
BMO also has ZAG:
We would be focusing solely on our only debt: the mortgage. It’s at 3.04%, which is great, but if interest rates rise we wouldn’t want to be stuck paying so much more. I don’t doubt mortgage rates will be going up again fairly soon.
You’ve got a great mortgage rate Daisy. Nice. I doubt rates will rise now that much, if any, with the U.S. avoiding tapering and keeping themselves in a pile of debt.
Good plan 😀 Buying bonds can in a rising rate environment can be risky. If I were to plan for rising interest rates I’d only buy bonds with short term durations like those under 3 years. I have some precious metals and other real assets that I feel will protect me against higher interest rates. But the curious thing is I have a gut feeling that the central banks of both Canada and the US won’t be raising their key lending rates for at least another year or so. I think Prime may stay at 3% until 2015. But that doesn’t mean mortgage rates won’t go up sooner because banks may become impatient lol, so it’s good to have some wiggle room and use the prepayment privileges if you have to 🙂
Agreed. If you need bonds, want bonds, go with short durations right now since long bonds will get hammered with rising rates. There is all the chatter about higher bond yields, and they have gone up a bit, but I don’t see it happening all at once.
If your retirement horizon is more than a decade away, why try and predict interest rate changes by buying only short term bonds? If your horizon is measured in decades you can’t lose with medium or longer term bonds.
Thanks for your comment Jamie.
Yes, my retirement horizon is about 10-15 years away. I’m not making any major investments in bonds, and haven’t done so for a few years. I keep an all-in-one bond product in my portfolio and that’s it. The average duration of the bonds I hold is about 7 years, so not that short.
I love that – while you’re clearly thinking about your strategy for the upcoming few years and taking into account both fact and conjecture – your ultimate plan is a boring one. In my experience, boring = good.A
Thanks Sandi, I appreciate your comment. Yeah, dull and boring investor and saver right here!
Hopefully you’ve recovered from Nelson’s presentation. Take care!
I just stick to my plan and try not to worry about any changing macro-trends. I don’t own any bonds, and have no plans to change my investing approach going forward.
If rising bond yields push down dividend stock prices then I’ll load up on some dividend payers, preferably the ones that grow their dividends regularly.
I have a variable rate mortgage and two-and-a-half years remaining on our initial 5-year term. I don’t anticipate prime rate to increase before our mortgage comes up for renewal, but if it does then that just reinforces my plan to pay off the entire balance in the next 6 years.
Smart man Robb.
My wife still has a few bonds in her portfolio but not much.
I’m looking forward to bond yields pushing stock prices lower. Time to buy. For now, eyeing some REITs. D.UN and others are priced well.