The "safe" part of your portfolio could do the most damage to your net worth over the next few years. Fixed income is normally associated with lower returns and lower risk than equities over long periods of time, but if interest rates are increasing from record lows, it's time for a refresher on the basics of bond pricing.
While chatting with a friend on Bay Street recently, he mentioned that many fixed income investors could be in for a rude awakening if interest rates do indeed start to creep up. Most intermediate level investors are familiar with the concept that bond prices are inversely correlated with changes in interest rates: bond prices fall when rates go up, and bond prices rise when rates go down. But many retail investors may not be aware of how this relationship changes depending on the general level of interest rates: Price changes are more volatile in lower interest rate environments.
Assume two identical companies need $100-million each to build factories. Let's further assume current interest rates are 5 per cent. Company A issues bonds today and offers to pay 7 per cent (to compensate for the increased risk of a corporate bond versus a GIC, for example). They get their money and the bonds start trading on the bond market.
Now let's assume that interest rates are increased by 1 per cent. Company B needs to build their factory now, but because rates increased they offer their bonds with an 8-per-cent interest rate to reflect the new going rate for debt. They raise their money and their bonds now trade in the bond market.
Looking at otherwise identical companies, would you rather buy bonds from Company A or Company B? If the bond prices were the same, you would pick Company B's bonds, which pay 8 per cent. But the price of Company A's bonds change to reflect the new cost of money. For every $100 of Company B's bonds, you are getting $8 in interest per year. In order to get the same $8 in interest on Company A's bonds, you would have to earn 7 per cent on $87.50. In other words, Company A's bonds drop in price from $100 to $87.50 to match the yield of Company B's bonds. That's a 12.5 per cent drop in price.
There's much more than just changing interest rates that affect bond prices, but clearly they are an important factor. This simple scenario is purely for demonstrative purposes.
Now, what happens if we do the same math with starting interest rates of 1 per cent?
Company A's bonds are issued at 3 per cent, the government raises rates from 1 per cent to 2 per cent, and Company B's bonds are issued at 4 per cent. How big is the change in Company A's bond price in this scenario?
Well, you could get $4 per year per $100 invested with Company B's bonds. To get that same 4 per cent yield when the interest payments are only $3 on Company A's bonds means you would have to pay $75 for Company A's bonds. That's a 25 per cent drop in price.
Think of it this way. If prevailing rates were 10 per cent, a 1-per-cent increase in the interest rate is a relative 10-per-cent change. If prevailing rates were 1 per cent, a 1-per-cent increase in the interest rate is a relative 100-per-cent change.
We are close to the latter scenario, folks.
Preet Banerjee is a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.