May 17 was a big day in investing for the year so far.
That’s when high-rate hysteria peaked. The five-year Government of Canada bond yield hit 2.33 per cent, compared with 0.91 per cent a year earlier. Bonds and bond funds were in full retreat at this point, and utility stocks, long an investor favourite, were being pushed steadily lower. What’s happened since then with interest rates is a lesson on why investors shouldn’t overreact to periodic shifts in financial markets.
High-rate hysteria was based on the fear of rising inflation and a resulting move higher in interest rates. For now, this concern has been shelved by a bunch of factors that include global trade tensions and political uncertainties in Europe, notably Italy. Canadian and U.S. government bonds, seen previously as a trap for foolish investors, are suddenly in demand again as a safe haven.
The yield on the five-year Canada bond was sitting just below 2 per cent as of June 26, which means a solid rally in bond prices (prices and yields move in opposite directions). Utility stocks have also perked up recently, and so have other rate-sensitive sectors such as real estate investment trusts.
Interest rates have been stuck at extreme lows for years, so it’s natural for investors to expect a big rebound at some point. But time and again in recent years, we’ve seen rising rate trends lose momentum. The lesson here is to accommodate rising rates in your portfolio mix, but in a measured way that won’t leave you offside if rates end up falling back again.
For example, you might want to have a modest bias in your bond holdings toward short-term bonds, or those maturing in five years or less. Short term bonds typically fall less severely in a rising rate environment, but they also offer lower yields than longer term bonds. By mixing short-term bonds and a more diversified bond fund, you get a little more defensive while still retaining a somewhat higher yield.
Investors nervous about price declines in their utility shares may want to reduce their exposure, but not sell out by any stretch. The recent rebound in the utility sector shows that if rates stabilize, investors will want these stocks in their portfolio again.
The fluctuations in bond yields since May 17 remind investors of the danger of being too extreme in aligning a portfolio to what appears to be a major shift in market conditions. Markets sometimes shift, and then shift back again.